Common Estate Planning Mistakes People Make

“Mortality never prevented the majority of human beings from behaving as though death were no more than an unfounded rumor” – Aldous Huxley

A Rocket Lawyer survey in 2014 indicated that 64% of Americans did not have a will. If you’re one of them, then this is a must-read.

The most common way to transfer assets to your heirs is also the messiest: to have a will that is so out-of-date that it doesn’t even relate to your property or estate anymore, to have your records scattered all over the place, to have social media, banking and email accounts whose passwords only you can find—and basically to leave a big mess for others to clean up. I’ve reviewed over a hundred wills and estate plans in my lifetime, and it never ceases to amaze me how out-of-date or incomplete some of them are.

Is there a better way?

Recently, a group of estate planning experts were asked for their advice on a better process to handle the transfer of assets at your death, and to articulate common mistakes. A list of mistakes, including a few that I identified during my reviews, are covered below:

Not regularly reviewing documents. What might have been a solid plan 5 to 15 years ago may not relate to your estate today. The experts recommended a full review every three to five years, to ensure that trustees, executors, guardians, beneficiaries and healthcare agents are all up-to-date. You might also consider creating a master document which lists all your social media and online accounts and passwords, so that your heirs can access them and close them down. Be sure your documents specifically authorize and instruct your executor to access and shut them down after your death.

Not leaving personal property disposition instructions, keys and passwords for your executor. Untold numbers of safes and safety deposit boxes have to either be drilled open or forced open by court order because no one else held the key or numeric combination. If you have a home or office safe, or a safety deposit box at a bank, make sure that your executor and/or trustee knows where the key(s) are, or what the combination is (and what bank location the safe deposit box is in). Even better, and to facilitate distribution, leave a signed inventory of the valuables left in there and who is to inherit them. Having a schedule of valuable property or heirlooms and who is designated to inherit them is invaluable to your executor after you’re gone. Don’t wait until after the will is executed to do this. Do it before you sign the will and make yourself a to-do to update the list at least once a year. Will your executor know where to find and be able to access all of your original estate planning documents?

Using a will instead of a revocable trust. This relates mostly to people who want to protect their privacy or pass their wealth to under-age children. When assets pass to heirs via a will, the transfer creates a public record that anybody can access and read. A revocable trust can be titled in your name, and you can control the assets as you would with outright ownership, but the assets simply pass to your designated successor upon death.

Establishing a longer term trust for a small amount of assets. If the trust distributes assets over multiple years, be sure the value of the trust assets justify the cost and burden of fiduciary administration. Creating a trust holding $50,000 worth of assets to distribute $10,000 to each of five beneficiaries over five years makes little financial sense.

Failure to require mandatory and timely annual income distributions. Not distributing income annually to the beneficiaries can subject the trust to a 35% maximum tax rate on all income over $12,500 (currently), a much steeper income tax schedule than that of any individual beneficiary. With an inexperienced trustee, he/she may not know that not distributing the income from the trust annually will likely result in much higher taxation. By specifically REQUIRING annual income distributions in the trust, an ignorant trustee has no choice, and can thereby avoid high trust tax rates, and the beneficiaries pay their own (likely lower) tax rates on their distributions.

Not carefully vetting the trustee. The role of the trustee is both a powerful and time consuming one: make sure the person is qualified, willing and able to devote the time to properly understand and execute the trust instructions. Be sure to ask your candidate if they’re willing to serve before naming them in your trust. Family members who may also be beneficiaries frequently become a source of conflict or present a conflict of interest, so you may want to try and appoint a trusted non-relative instead if at all possible, or designate a corporate trustee. Also, provide in the trust document for reasonable compensation, expense reimbursement and indemnification of the trustee.

Failing to fund the revocable trust. You’ve set up the trust, but now you and your team of professionals have to transfer title to your properties out of your name and into the trust, with you as the initial trustee. If you forget to do this, then the entire purpose of the trust is wasted. Be sure to specify at least two successor trustees.

Having assets titled in a way that conflicts with the will or trust. You should always pay close attention to account beneficiary designations, because they—not your will or trust—determine who will receive your life insurance proceeds, IRA distributions and employer retirement plan assets. Meanwhile, assets (like a home) owned in joint tenancy with rights of survivorship will pass directly to the surviving joint tenant, no matter what the will or trust happens to say. Review beneficiary designations at least once a year. Does that old employer 401(k) beneficiary still list your former spouse as the beneficiary?

Not using the annual gift exemption. Each person can gift $14,000 a year tax-free to heirs without affecting the value of their $5.49 million lifetime estate/gift tax exemption. That means a husband and wife with four children could theoretically gift the kids $112,000 a year tax-free. Over time, that can reduce the size of a large estate potentially below the gift/estate exemption threshold, and in states where there is an estate or inheritance tax, it can help as well.

Not understanding the generation-skipping transfer tax. A husband and wife can each leave estate values of $5.49 million to any combination of individuals. But if there’s anything left over, there’s a 40% federal estate tax on those additional assets left to heirs in the next generation (the children), and an additional 40% on assets left to the generation after that (the grandchildren). Better to transfer $5.49 million out of the estate before death (tax-free, since this fills up the lifetime gift exemption) into a dynastic trust for the benefit of the grandchildren. You can also transfer that annual $14,000 to grandchildren. If your estate is that large, it is imperative that you seek the assistance of an estate planning attorney unless you favor leaving half or more of your assets to your federal and state governments.

Not taking action because of the possibility of estate tax repeal. Yes, the Republican leadership in Congress includes, on its wish list, the total repeal of those estate taxes (the estate tax is based on the value of the estate on the date of death). But what if there’s no action, or a compromise scuttles the estate tax provisions at the last minute? Federal wealth transfer taxes have been enacted and repealed three times in U.S. history, so there’s no reason to imagine that even if there is a repeal, the repeal will last forever. Meanwhile, dynastic trusts and other estate planning tactics provide tangible benefits even without the tax savings, including protecting assets from lawsuits and claims. And while the estate tax may be going away, the tax on estate and trust income is not, and may become a focus of the IRS as replacements for lost revenue are sought out.

Thinking that having just a will is enough. A health care directive (to allow your designee to speak on your behalf regarding health care decisions when you can’t) and a durable power of attorney (to perform duties on your behalf when you’re possibly incapacitated) are essential for every adult to have, in addition to a will.

Leaving too much, too soon, to younger heirs. Nothing can harm emerging adult values quite like realizing, as they start their productive careers, that they actually never need to work a day in their lives. The alternative? Create a trust controlled by a trusted individual (again, preferably not a family member or beneficiary) or a corporate trust company until the beneficiaries reach a more mature stage of their lives, perhaps 30-35 years old.

There are so many other estate planning provisions that may be unique to you, your family and your business. A fee paid to a legal professional who specializes in estate planning is a final act of love to your loved ones to help them understand your dying intentions, and minimize the hassles inherent in estate administration and disposition.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

Tax Reform or Accountant’s Re-employment Act?

For as long as I can remember, tax reduction and simplification have been on the table for congress and past presidents. So why not President Trump? File your next tax return on a postcard (not likely)? I might be a bit cynical, but the only result of the next tax act I see will be extending my employment as a tax planner and preparer for the foreseeable future.

I sincerely doubt I’ll see significant tax simplification in my lifetime, so my fellow CPA’s and Turbotax employees can probably breathe a sigh of relief-their jobs are likely safe for years to come.

You can be forgiven if you’re skeptical that Congress will be able to completely overhaul our tax system after multiple failures to overhaul our health care system, but professional advisors are studying the newly-released nine-page proposal closely nonetheless. We only have the bare outlines of what the initial plan might look like before it goes through the Congressional sausage grinder:

First, we would see the current seven tax brackets for individuals reduced to three — a 12% rate for lower-income people (up from 10% currently), 25% in the middle and a top bracket of 35%. The proposal doesn’t include the income “cutoffs” for the three brackets, but if they end up as suggested in President Trump’s tax plan from the campaign, the 25% rate would start at $75,000 (for married couples–currently $75,900), and joint filers would start paying 35% at $225,000 of income (currently $416,700).

The dreaded alternative minimum tax, which was created to ensure that upper-income Americans would not be able to finesse away their tax obligations altogether, would be eliminated under the proposal. But there is a mysterious notation that Congress might impose an additional rate for the highest-income taxpayers, to ensure that wealthier Americans don’t contribute a lower share than they pay today.

The initial proposal would nearly double the standard deduction to $12,000 for individuals and $24,000 for married couples, and increase the child tax credit, now set at $1,000 per child under age 17. (No actual figure was given.)

At the same time, the new tax plan promises to eliminate many itemized deductions, without telling us which ones other than a promise to keep deductions for home mortgage interest and charitable contributions. The plan mentions tax benefits that would encourage work, higher education and retirement savings, but gives no details of what might change in these areas.

The most interesting part of the proposal is a full repeal of the estate tax and generation-skipping estate tax, which affects only a small percentage of the population but results in an enormous amount of planning and calculations for those who ARE affected. Anyone with enough money to be subject to the estate tax, has probably paid lawyers and accountants enough for planning to avoid paying a single dollar of it.

The plan would also limit the maximum tax rate for pass-through business entities like partnerships and limited liability companies (LLC’s) to 25%, which might allow high-income business owners to take their gains through the entity, rather than as personal (1040) income and avoid the highest personal tax brackets.

Finally, the tax plan would lower America’s maximum corporate (C-Corporation) tax rate from the current 35% to 20%. To encourage companies to repatriate profits held overseas, the proposal would introduce a 100% exemption for dividends from foreign subsidiaries in which the U.S. parent owns at least a 10% stake, and imposes a one-time “low” (not specified) tax rate on wealth already accumulated overseas.

What are the implications of this bare-bones proposal? The most obvious, and most remarked-upon, is the drop that many high-income taxpayers would experience, from the current 39.6% top tax rate to 35%. That, plus the elimination of the estate tax, in addition to the lowering of the corporate tax (potentially leading to higher dividends) has been described as a huge relief for upper-income American investors, which could fuel the notion that the entire exercise is a big giveaway to large donors. But the mysterious “surcharge” on wealthier taxpayers might taketh away what the rest of the plan giveth.

But many Americans with S corporations, LLCs or partnership entities (known as pass-through entities because their income is reported on the owners’ personal returns and therefore no company level tax is paid) would potentially receive a much greater windfall, if they could choose to pay taxes on their corporate earnings at 25% rather than nearly 40% currently. (No big surprise: The Trump organization is a pass-through entity.)

A huge unknown is which itemized deductions would be eliminated in return for the higher standard deduction. Would the plan eliminate the deduction for state and local property and income taxes, which is especially valuable to people in high-tax states such as New York, New Jersey and California, and in general to higher-income taxpayers who pay state taxes at the highest rate? Note that on average, only about 35% of Americans itemize their deductions on Schedule A, most of them higher income taxpayers.

Currently, about one-third of the 145 million households filing a tax return — or roughly 48 million filers — claim state and local tax deductions. Among households with income of $100,000 or more, the average deduction for state and local taxes is around $12,300. Some economists have speculated that people earning between $100,000 and around $300,000 might wind up paying more in taxes under the proposal than they do now. Taxpayers with incomes above $730,000 would hypothetically see their after-tax income increase an average of 8.5 percent.

Big picture, economists are in the early stages of debating how much the plan might add to America’s soaring $20 trillion national debt. One back-of-the-envelope estimate by a Washington budget watchdog estimated that the tax cuts might add $5.8 trillion to the debt load over the next 10 years. According to the Committee for a Responsible Federal Budget analysis, Republican economists have identified about $3.6 trillion in offsetting revenues (mostly an assumption of increased economic growth), so by the most conservative calculation the tax plan would cost the federal deficit somewhere in the $2.2 trillion range over the next decade.

Others, notably the Brookings Tax Policy Center (see graph) see the new proposals actually raising tax revenues for individuals (blue bars), while mostly reducing the flow to Uncle Sam from corporations.

CA - 2017-9-30 - Tax Reform Proposal_2

These cost estimates have huge political implications for whether a tax bill will ever be passed. Under a prior agreement, the Senate can pass tax cuts with a simple majority of 51 votes — avoiding a filibuster that might sink the effort — only if the bill adds no more than $1.5 trillion to the national debt during the next decade.

That means compromise. To get the impact on the national debt below $1.5 trillion, Congressional Republicans might decide on a smaller cut to the corporate rate, to something closer to 25-28%, while giving typical families a smaller 1-percentage point tax cut (gee…thanks?). Under that scenario, multi-national corporations might be able to bring back $1 trillion or more in profit at unusually low tax rates, and most families might see a modest tax cut that will put a few hundred extra bucks in their pockets.

Alternatively, Congress could pass tax cuts of more than $1.5 trillion if the Republicans could flip enough Democratic Senators to get to 60 votes. The Democrats would almost certainly demand large tax cuts for lower and middle earners, potentially lower taxes on corporations and higher taxes on the wealthy. Would you bet on that sort of compromise?

We shall see, and I’ll keep you posted on tax developments. For now, put away that post card–you’re probably going to need an envelope and more postage.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

Sources:
https://www.yahoo.com/finance/news/trump-overpromising-tax-cuts-205013012.html
https://www.aei.org/publication/the-big-six-tax-reform-framework-can-you-dynamically-score-a-question-mark/
https://www.washingtonpost.com/blogs/plum-line/wp/2017/09/27/trumps-new-tax-plan-shows-how-unserious-republicans-are-about-governing/?tid=sm_tw&utm_term=.d37e0bcf718d
https://www.yahoo.com/finance/news/hidden-tax-hikes-trumps-tax-cut-plan-202041809.html
https://www.yahoo.com/finance/news/republicans-700-million-problem-could-173027048.html
https://www.yahoo.com/finance/news/trumps-tax-plan-just-got-180000645.html
The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

 

2017 Retirement Contribution Limits Unchanged

Retirement plan contributions are supposed to be indexed and adjusted annually in line with the change in the rate of inflation. But only in the governmental fantasy world of non-inflation are adjustments not necessary.

That is to say, in case you missed it, the contribution limits to your 401(k) plan, IRA and Roth IRA—set by the government each year based on the inflation rate—will not go up in 2017.  Just like this year, you will be able to defer up to $18,000 of your paycheck to your 401(k), and individuals over age 50 will still be able to make a “catch-up” contribution of an additional $6,000.  (The same limits apply to 403(b) plans and the federal government’s new Thrift Savings Plan.)  Your IRA and Roth IRA contributions will continue to max out at $5,500, plus a $1,000 “catch-up” contribution for persons 50 or older.

SEP IRA and Solo 401(k) contribution limits, meanwhile, will go up from $53,000 this year to $54,000 in 2017.

The government has made small changes to the income limits on who can make deductions to a Roth IRA and who can claim a deduction for their contribution to a traditional IRA.  The phaseout schedule (income range) for single filers for 2016 starts at $117,000 and contributions are entirely phased out at $132,000; for joint filers the current range is $186,000 to $196,000.  In 2017, the single phaseout will run $1,000 higher, from $118,000 to $133,000, and the joint phaseout threshold will rise $2,000, to $188,000 up to $198,000.  Single persons who have a retirement plan at work will see the income at which they can no longer deduct their IRA contributions go up $1,000 as well, with the phaseout starting at $62,000 and ending at $72,000.  Couples will see their phaseout schedule rise to $99,000 to $119,000.

If you would like to review your retirement plan options, current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

Sources:

http://money.cnn.com/2016/10/27/retirement/401k-ira-contribution-2017/index.html?iid=Lead

http://www.investopedia.com/articles/retirement/111516/2017-cola-adjustments-overview.asp?partner=mediafed

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

Roth IRA Conversions after Age 70-1/2

A Roth IRA conversion allows you to move a sum of money from a traditional/rollover IRA into a Roth IRA, pay the taxes due, and thereby convert the future distributions into a tax-free stream out of the Roth IRA for yourself or your heirs.  You probably already know that the IRS requires you to start taking mandatory distributions from your traditional IRA when you turn 70 1/2, even if you don’t actually need the money.  A Roth IRA has no such annual minimum distribution requirement for the original owner and spouse. So the question is: can you do a Roth conversion at that late date, and thereby defer distributions forever?

The answer is that you CAN do a Roth conversion at any time, including after age 70 1/2.  But that might not be ideal tax planning.  Why?  Because at the time of the conversion, you would have to pay ordinary income taxes on the amount converted—basically, paying Uncle Sam up-front for what you would owe on all future distributions.  So, from a tax standpoint, you’re either paying taxes on yearly distributions or all at once.  (Or, if it’s a partial conversion, on the amount transferred over.)  If the goal was to avoid having to pay taxes on that money until you needed it, the conversion kind of defeats the purpose. Unless, of course, you have little other taxable income, and adding a Roth Conversion amount costs you little or nothing in taxes

The traditional reason people made Roth conversions was to pay taxes at a lower rate today than the rate they expect to have to pay on distributions in the future.  They might also want to convert in order to leave the Roth IRA dollars to heirs who might be in a higher tax bracket (keep in mind that a heir who is not your spouse is required to take a minimum, albeit non-taxable, distribution from a Roth IRA).  But with the new Republican Administration taking over, and Republicans controlling both houses of Congress, tax rates are odds-on favorites to go down, not up, in the near future.

If you still want to go ahead and make a conversion after the mandatory distribution date, the law says that you have to take your mandatory withdrawal from your IRA before you do your conversion. That means that you can’t make a 100% conversion of your traditional IRA if you are subject to minimum distribution requirements.  Regardless, you or your tax advisor should “run the numbers” to ensure that you understand the taxes and tax rates that apply before and after the Roth Conversion.

If you would like to review your current investment portfolio or discuss any other tax or financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

Source:
http://time.com/money/4568635/roth-ira-conversion-year-turn-70-%C2%BD/?xid=tcoshare

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

An Estate Plan for your Digital Assets

In recent years, a new category of assets has appeared on the scene, which can be more complicated to pass on at someone’s death than stocks, bonds and cash.  The list includes such valuable property as digital domain names, social media accounts, websites and blogs that you manage, and pretty much anything stored in the digital “cloud.”  In addition, if you were to die tomorrow, would your heirs know the pass-codes to access your iPad or smartphone?  Or, for that matter, your e-mail account or the Amazon.com or iTunes shopping accounts you’ve set up?  Would they know how to shut down your Facebook account, or would it live on after your death?

A service called Everplans has created a listing of these and other digital assets that you might consider in your estate plan, and recommends that you share your logins and passwords with a digital executor or heirs.  If the account or asset has value (airline miles or hotel rewards programs, domain names) these should be transferred to specific heirs—and you can include these bequests in your will.  Other assets should probably be shut down or discontinued, which means your digital executor should probably be a detail-oriented person with some technical familiarity.

The site also provides a guide to how to shut down accounts; click on “F,” select “Facebook,” and you’re taken to a site (https://www.everplans.com/articles/how-to-close-a-facebook-account-when-someone-dies) which tells you how to deactivate or delete the account.  Note that each option requires the digital executor to be able to log into the site first; otherwise that person would have to submit your birth and death certificates and proof of authority under local law that he/she is your lawful representative.  (The executor can also “memorialize” your account, which means freezing it from outside participation.)

The point here is that even if you know who would get your house and retirement assets if you were hit by a bus tomorrow, you could still be leaving a mess to your heirs unless you clean up your digital assets as well.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Sources:

https://www.everplans.com/articles/a-helpful-overview-of-all-your-digital-property-and-digital-assets

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

It’s 2015: Do You Know Who Your Beneficiaries Are?

Many IRA owners may not be aware that after their death, the primary beneficiary — usually the surviving spouse — may have the right to transfer part or all of the IRA assets into another account.

Many investors have taken advantage of pretax contributions to their company’s employer-sponsored retirement plan and/or make annual contributions to an IRA. If you participate in a qualified plan program you may be overlooking an important housekeeping issue: beneficiary designations.

An improper designation could make life difficult for your family in the event of your untimely death by putting assets out of reach of those you had hoped to provide for and possibly increasing their tax burdens. Further, if you have switched jobs, become a new parent, been divorced, or survived a spouse or even a child, your current beneficiary designations may need to be updated.

Consider the “What Ifs”

In the heat of divorce proceedings, for example, the task of revising one’s beneficiary designations has been known to fall through the cracks. While a court decree that ends a marriage does terminate the provisions of a will that would otherwise leave estate proceeds to a now-former spouse, it does not automatically revise that former spouse’s beneficiary status on separate documents such as employer-sponsored retirement accounts and IRAs.

Many IRA owners may not be aware that after their death, the primary beneficiary — usually the surviving spouse — may have the right to transfer part or all of the IRA assets into another account. Take the case of the IRA owner who has children from a previous marriage. If, after the owner’s death, the surviving spouse moved those assets into his or her own IRA and named his or her biological children as beneficiaries, the original IRA owner’s children could legally be shut out of any benefits.

Also keep in mind that the law requires that a spouse be the primary beneficiary of a 401(k) or a profit-sharing account unless he/she waives that right in writing. A waiver may make sense in a second marriage — if a new spouse is already financially set or if children from a first marriage are more likely to need the money. Single people can name whomever they choose. And non-spouse beneficiaries are now eligible for a tax-free transfer to an IRA.

The IRS has also issued regulations that dramatically simplify the way certain distributions affect IRA owners and their beneficiaries. Consult your tax advisor on how these rule changes may affect your situation.

To Simplify, Consolidate

Elsewhere, in today’s workplace, it is not uncommon to switch employers every few years. If you have changed jobs and left your assets in your former employers’ plans, you may want to consider moving these assets into a rollover IRA. Consolidating multiple retirement plans into a single tax-advantaged account can make it easier to track your investment performance and streamline your records, including beneficiary designations.

Review Your Current Situation

If you are currently contributing to an employer-sponsored retirement plan and/or an IRA, contact your benefits administrator — or, in the case of the IRA, the financial institution — and request to review your current beneficiary designations. You may want to do this with the help of your tax advisor or estate planning professional to ensure that these documents are in synch with other aspects of your estate plan. Ask your estate planner/attorney about the proper use of such terms as “per stirpes” and “per capita” as well as about the proper use of trusts to achieve certain estate planning goals. Your planning professional can help you focus on many important issues, including percentage breakdowns, especially when minor children and those with special needs are involved.

Finally, be sure to keep copies of all your designation forms in a safe place and let family members know where they can be found.

This communication is not intended to be tax or legal advice and should not be treated as such. Each individual’s situation is different. If you would like to review your current beneficiary designations or discuss any other estate or financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Interest Rates: What’s the Connection to Your Portfolio?

When it comes to interest rates, one thing’s for certain: What goes down will eventually come up.

The federal funds rate — the rate on which short-term interest rates are based — has varied significantly over time. It’s a cycle of ups and downs that can affect your personal finances — your credit card rates, for example. But what about less familiar effects, like those that interest rate changes can have on your investments? Understanding the relationship between bonds, stocks, and interest rates could help you better cope with inevitable changes in our economy and your portfolio.

Bond Market Mechanics

Interest rates often fall in a weak economy and rise as it strengthens. As the economy gathers steam, companies experience higher costs (wages and materials) and they usually borrow money to grow. That’s where bond yields and prices enter the equation.

What is yield? It’s a measure of a bond’s return based on the price the investor paid for it and the interest the bond will pay. Falling interest rates usually result in declining yields. As rates spiral downward, businesses and governments “call” or redeem the existing bonds they’ve issued that carry higher interest rates, replacing them with new, lower-yielding bonds. Why? To save money. (A homeowner refinances his or her home at a lower mortgage rate for the same reason.)

Interest rate changes affect bond prices in the opposite way. Declining interest rates usually result in rising bond prices and vice versa — think of it as a seesaw relationship. What causes this change? When interest rates rise, investors flock to new bonds because of their higher yields. Therefore, owners of existing bonds reduce prices in an attempt to attract buyers.

Investors who hold on to bonds until maturity aren’t concerned with this seesaw relationship. But bond fund investors may see its effects over time.

Evaluating Equities

Interest rate changes can also affect stocks. For instance, in the short term, the stock market often declines in the midst of rising interest rates because companies must pay more to borrow money for expansion and capital improvements. Increasing rates often impact small companies more than large, well-established firms. That’s because they usually have less cash, shorter track records, and other limited resources that put them at higher risk. On the other hand, a drop in interest rates may result in higher stock prices if corporate profits increase.

So why do some stocks increase in value even as interest rates rise, or vice versa? Because industry or company-specific factors — such as the development of a new product — can impact stock prices more than rate changes.

Taking Action

Is there anything an investor can do when faced with interest rate uncertainty? You bet. Although you can’t change interest rates, you can assemble a portfolio that can potentially ride out the inevitable ups and downs. Risk reduction begins with diversifying your investments in as many ways as possible.

Let’s start with equities. Consider investing across different sectors, because no one knows which of today’s industries will fuel the next expansion. Also be aware that some sectors — such as energy — are more economically sensitive than others, which can lead to increased volatility. Additionally, consider stocks or stock mutual funds that invest in different market caps (sizes) and have different investing styles, such as both value and growth investing.

On to fixed-income investments: Do your bond funds hold bonds of different maturities — short, medium and long-term — and types, such as government and corporate? Different types of bonds react in their own way to interest rate changes. Long-term bonds, for instance, are more sensitive to rate changes than short-term bonds.

Interest rates will always fluctuate in response to economic conditions. Rather than trying to guess the Federal Reserve’s next move, why not concentrate on creating a portfolio that will serve your needs well — no matter which way rates go?

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.