Federal Student Loan Forgiveness and Delayed Repayment to 2023

On August 24, 2022, just a few days before federal student loan repayment was set to resume, President Biden announced a plan for additional student loan debt relief.

Federal student loan repayment was originally halted in March 2020 at the start of the pandemic. The new plan: 1) Extends the payment moratorium through the end of the year; 2) Offers partial debt cancellation; 3) Includes proposed updates to the Public Service Loan Forgiveness program and 4) Introduces a new income-based repayment plan.

What’s new

Here’s the new framework for federal student loans:

Loan Cancellation. The plan will cancel $10,000 of federal student loan debt for borrowers with an adjusted gross income less than $125,000 ($250,000 for married couples filing jointly). The loan cancellation increases to $20,000 for borrowers who are Pell Grant recipients (1) (a Pell Grant is a federal financial aid grant award to students from low-income households.) Eligibility is based on income from 2020 or 2021, but not 2022.(2)

The Department of Education estimates that 21% of the borrowers eligible for relief are 25 years and younger, 44% are ages 26 to 39, and the remaining 35% are ages 40 and up, including 5% who are senior citizens. The Department also estimates that approximately 27 million borrowers (more than 60% of the borrower population) are Pell Grant recipients and will be eligible to receive up to $20,000 in debt relief. (3).

Payment Pause Extended: The pause on federal student loan repayment is being extended one “final” time through December 31, 2022. President Biden’s announcement states that “borrowers should expect to resume payment in January 2023.”(4) In practice, borrowers should expect to hear from their loan servicer at least three weeks before their first payment is due.

Changes  to the Public Service Loan Forgiveness (PSLF) Program: Borrowers who are employed by a nonprofit organization, the military, or the government may be eligible to have their federal student loans forgiven through the PSLF program due to time-sensitive changes. These temporary changes waive certain eligibility criteria for the program and make it easier for borrowers to receive credit for past periods of repayment that would otherwise not qualify for PSLF. These changes expire on October 31, 2022.

Important note: Borrowers who might qualify for loan forgiveness or credit under the PSLF program due to these time-sensitive changes must apply to the program before October 31, 2022. Borrowers can visit the administration’s PSLF website for more information.

In addition, the Department has proposed allowing certain kinds of deferments and forbearances, such as those for Peace Corps and AmeriCorps service, National Guard duty, and military service, to count toward PSLF.

A New  Income-based Repayment Plan. The Department of Education is proposing a new income-driven repayment plan that does the following:

• For undergraduate loans, caps monthly payments at 5% of a borrower’s discretionary income (currently borrowers must pay 10% of their discretionary income)
• For borrowers with original loan balances of $12,000 or less, the loan balance would be forgiven after 10 years of payments (currently borrowers must repay their loans for 20 years)
• Raises the amount of income considered non-discretionary, with the result that a borrower who earns an annual salary based on a $15 minimum wage would not have to make any payments (the monthly payment would be calculated at $0)
• Covers a borrower’s unpaid monthly interest, so that a borrower’s loan balance won’t grow due to interest as long as the borrower is making monthly payments (under current income-driven repayment plans, a borrower’s loan balance can grow even if the borrower continues making monthly payments, because the interest keeps accruing)
• Makes income recertification automatic, which will allow the Department of Education to automatically retrieve a borrower’s income information every year instead of making borrowers recertify their income annually

Will my loans be cancelled automatically?

For most borrowers, no. The Department of Education will be creating a “simple” application for borrowers to claim relief, which will be available by early October. Borrowers who would like to be notified when the application is open can sign up on the Department’s subscription page. Once borrowers complete an application, their loan cancellation should be processed within four to six weeks. The Department recommends that borrowers apply before November 15 in order to receive loan cancellation before the payment pause expires on December 31, 2022. (The Department will still process applications even after the pause expires.)

Some borrowers, however, may be eligible to have their loans cancelled automatically because the Department already has their income data on record.

Are current students eligible for loan cancellation?

Yes, current students are eligible for loan cancellation, provided their loan was obtained before July 1, 2022. However, borrowers who are dependent students need to qualify based on parental income, not their own income.(5)

Are  graduate students eligible for loan cancellation?

Yes, provided income limits are met and it is a federal loan, such as a Direct Loan or Grad PLUS Loan. Private loans are not eligible.

Do parent PLUS Loans qualify for cancellation?

Yes, provided the income limits are met. Any private loans taken out by parents to pay their child’s college education are not eligible.

Will I be taxed on my cancelled debt?

At the federal level, no. At the state level, maybe. Any student loan relief will not be treated as taxable income at the federal level, thanks to provisions in the American Rescue Plan Act of 2021. However, a handful of states that have not yet aligned their laws with this Act could still tax the amount of student debt forgiven unless they act to amend their laws and affirmatively exclude this debt.

I have more than $10,000 in student loan debt. Will my monthly payment be adjusted after cancellation?

It depends. Borrowers who are already in an income-driven repayment plan generally won’t see their monthly payment change because their payment is based on their discretionary income and household size, not their outstanding loan balance. By contrast, borrowers who are in a fixed payment plan should have their monthly payment recalculated by their loan servicer because their outstanding balance will be lower after loan cancellation, which should result in a lower monthly payment.

I made monthly payments during the payment pause. Can I still qualify?

According to the Department of Education, borrowers who continued to make payments on their federal student loans after March 13, 2020 will still qualify for loan cancellation (assuming they meet the income guidelines). Borrowers can request a refund by calling their loan servicer directly. According to Mark Kantrowitz, a financial aid and student loan expert, only 1.2% of borrowers continued to make payments during the payment pause.(6)

If you would like to review your current investment portfolio or discuss any college planning or loan repayment 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.

1) U.S. Department of Education, 2022

2) The New York Times, August 25, 2022

3-5) White House Fact Sheet, August 24, 2022

6) The Wall Street Journal, August 25, 2022

Some Cures For Your “Social InSecurity”

One of the most common questions I hear from clients and prospects concerns the viability of the social security system and the likelihood it will be solvent enough to pay their benefits when they eventually reach retirement age. Their default instinct is to draw social security at the earliest possible age in case benefits were to run out prematurely. As you’ll read below, the Social Security program has many possible tweaks to help extend the payment of benefits for many decades to come and should help alleviate much of your Social InSecurity.

With approximately 94% of American workers covered by Social Security and 65 million people currently receiving benefits, keeping Social Security healthy is a major concern. According to the Social Security Administration, Social Security isn’t in danger of going broke — it’s financed primarily through payroll taxes — but its financial health is declining, and future benefits may eventually be reduced unless Congress acts.

Each year, the Trustees of the Social Security Trust Funds release a detailed report to Congress that assesses the financial health and outlook of this program. The most recent report, released on June 2, 2022, shows that the effects of the pandemic were not as significant as projected in last year’s report — a bit of good news this year.

Overall, the news is mixed for Social Security

The Social Security program consists of two programs, each with its own financial account (trust fund) that holds the payroll taxes that are collected to pay Social Security benefits. Retired workers, their families, and survivors of workers receive monthly benefits under the Old-Age and Survivors Insurance (OASI) program; disabled workers and their families receive monthly benefits under the Disability     Insurance (DI) program. Other income (reimbursements from the General Fund of the U.S. Treasury and income tax revenue from benefit taxation) is also deposited in these accounts.

Money that’s not needed in the current year to pay benefits and administrative costs is invested (by law) in special government-guaranteed Treasury bonds that earn interest. Over time, the Social Security Trust Funds have built up reserves that can be used to cover benefit obligations if payroll tax income is insufficient to pay full benefits, and these reserves are now being drawn down. Due to the aging population and other demographic factors, contributions from workers are no longer enough to fund current benefits.

In the latest report, the Trustees estimate that Social Security will have funds to pay full retirement and survivor benefits until 2034, one year later than in last year’s report. At that point, reserves will be used up, and payroll tax revenue alone would be enough to pay only 77% of scheduled OASI benefits, declining to 72% through 2096, the end of the 75-year, long-range projection period.

The Disability Insurance Trust Fund is projected to be much healthier over the long term than last year’s report predicted. The Trustees now estimate that it will be able to pay full benefits through the end of 2096. Last year’s report projected that it would be able to pay scheduled benefits only until 2057. Applications for disability benefits have been declining substantially since 2010, and the number of workers receiving disability benefits has been falling since 2014, a trend that continues to affect the long-term outlook.

According to the Trustees report, the combined reserves (OASDI) will be able to pay scheduled benefits until 2035, one year later than in last year’s report. After that, payroll tax revenue alone should be sufficient to pay 80% of scheduled benefits, declining to 74% by 2096. OASDI projections are hypothetical, because the OASI and DI Trust Funds are separate, and generally one program’s taxes and     reserves cannot be used to fund the other program. However, this could be changed by Congress, and combining these trust funds in the report is a way to illustrate the financial outlook for Social Security as a whole.

All projections are based on current conditions and best estimates of likely future demographic, economic, and program-specific conditions, and the Trustees acknowledge that the course of the pandemic and future events may affect Social Security’s financial status.

You can view a copy of the 2022 Trustees report at ssa.gov.

Many options for improving the health of Social Security

The last 10 Trustees Reports have projected that the combined OASDI reserves will become depleted between 2033 and 2035. The Trustees continue to urge Congress to address the financial challenges facing these programs so that solutions will be less drastic and may be implemented gradually, lessening the impact on the public. Many options have been proposed, including the ones listed below. Combining some of these may help soften the impact of any one solution:

  • Raising the current Social Security payroll tax rate (currently 12.4%). Half is currently paid by the employee and half by the employer (self-employed individuals pay the full 12.4%). An immediate and permanent payroll tax increase of 3.24 percentage points to 15.64% would be needed to cover the long-range revenue shortfall.
  • Raising or eliminating the ceiling on wages subject to Social Security payroll taxes ($147,000 in 2022).
  • Raising the full retirement age beyond the currently scheduled age of 67 (for anyone born in 1960 or later).
  • Raising the early retirement age beyond the current age of 62.
  • Reducing future benefits. To address the long-term revenue shortfall, scheduled benefits would have to be immediately and permanently reduced by about 20.3% for all current and future beneficiaries, or by about 24.1% if reductions were applied only to those who initially become eligible for benefits in 2022 or later.
  • Changing the benefit formula that is used to calculate benefits.
  • Calculating the annual cost-of-living adjustment (COLA) for benefits differently.

A comprehensive list of potential solutions can be found at ssa.gov.

As for when Congress will act to fix the system, in my opinion, it will probably be at the last minute when it becomes a crisis. But make no mistake-Congress will act, and any rumors or stories that social security won’t be around for the long term are simply false. Any member of Congress who votes against fixing and extending the system’s heath won’t be re-elected, and therefore you know they eventually will.

As for when you should consider drawing your own social security benefits, the unsatisfying answer is: it depends. Whether you should draw benefits at your early retirement age (usually 62), full retirement age (usually 67) or latest retirement age (70), depends on your financial situation, your spending needs, expected longevity and other factors. Only working with a financial planner or a comprehensive social security optimizer can help you figure out the optimal timeframe to claim social security. The right or wrong decision can increase or decrease your lifetime benefits by five or six zeroes—it’s worth the time and effort to do the analysis. We can, of course, help.

If you would like to review your current investment portfolio or discuss your social security benefits, 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.

What’s going on in the Markets June 20, 2022

With ten days to go in the 2nd calendar quarter and the end of the first half of 2022, we’ve witnessed one of the worst yearly starts in the markets since 1962 with a decline of about 23% in the S&P 500 index. This makes this year the 3rd worst start for the index in market history.  

The good news? Of the fourteen other worst starts to the year since 1931, ten of them went on to turn in positive returns for the rest of the year, although only five of those fourteen years turned things around and closed with positive returns for the entire year.

Mid-term election years (the 2nd year of a president’s term) have historically been lackluster, but that doesn’t entirely explain why this year has been so awful. Of course, the same culprits outlined in my What’s Going on in the Markets May 8, 2022 newsletter are still front and center today: 1. The war in the Ukraine; 2. Rising inflation; 3. Higher interest rates. A resolution in any of these three culprits could send the markets on a big trek higher.

To be fair, the markets were rife with speculation in all manners of stocks, special purpose acquisition companies (SPACs), initial public offerings, crypto-currencies, non-fungible tokens (NFTs) and other insane valuations of art, homes, antiques, etc. Most of this rampant speculation was fueled by the unprecedented fiscal and monetary stimulus unleashed in the markets by the Federal Reserve and Federal Government to combat a potential economic depression caused by COVID-19. As happens most often, a pendulum that swings too far in one direction must swing too far in the other direction to correct the excess. That’s the nature of cycles-both economic and markets.

From the pandemic low in March 2020 to the high in January 2022, the S&P 500 index more than doubled (+108%), so a market that moves that far in less than two years would historically be expected to give back (retrace) some of those gains at some point. To most students of long-term markets, giving back 50% or more of those gains would not be unusual at all before the uptrend might resume. At a closing level of about 3,678 as of last Friday, that would take the S&P 500 index to around 3,500, about 5% lower than Friday’s close. Nothing says it must stop there, but that level historically would be expected to generate at least a decent bounce or short-term rally.

Adding insult to injury, this has also been one of the worst starts in over 40 years in the bond markets. Long adding ballast to portfolios and a relative haven from the stock market storms, bonds on average are down over 12% year-to-date, with long term treasuries down over 24%. Even 1–3 year treasury bills are down about 3.7%, making even the safest and shortest of duration government bonds not immune from the carnage. Of course, when bond prices decline, their yields increase, so they become more attractive for new investments.

The perfect storm of a bond and stock market decline means that there have been few places to hide, other than energy and commodity stocks. Of course, energy and commodity stock outperformance mean higher prices for goods, which is at the heart of the inflation problem we now have.

Inflation Marches Higher

When so much stimulus enters the economy and markets in a short time, inflation inevitably rears its ugly head. Think of fiscal and monetary stimulus as money printing, and you can quickly understand how adding so many dollars to the money supply would tend to de-value those dollars. Indeed, when the inflation numbers were released for April and May (8.6% and 8.4% consumer price index respectively), they were higher than expected.  Relief in the supply chain logjam was not enough to offset the increased cost of labor, energy, and commodities (mostly raw materials and foodstuff).

Obviously, inflation at this level cannot be sustained longer term and needs to be tamed before it crashes the economy as consumers begin having trouble affording necessities, let alone discretionary purchases. It’s one of the two mandates of the Federal Reserve (The Fed): to reel in inflation using the tools at their disposal to prevent an economic crash.

Interest Rate Hikes

The dual mandates of The Fed are to:

1. Maintain price stability (by keeping inflation to 2% or less) and,

2. Ensure maximum employment.

With unemployment at historic lows, maintaining price stability is currently job #1 for The Fed.

When the pandemic hit, you may recall that The Fed immediately reduced short-term interest rates from 2.25% to 0% to counter the expected economic contraction effects of the COVID-19 pandemic. They also launched one of the biggest asset purchase plans (bond buying) in history as an emergency measure to ensure enough liquidity in the financial system to keep the economy and commerce from seizing up. The Fed kept these asset purchases up through March of this year (far longer than necessary in my opinion), thereby flooding the markets with stimulus.

Beginning in April, The Fed raised short term interest rates by 0.25% for the first time and announced that the bonds bought over the past several years would be sold off over time. Of course, if injecting the markets with all that stimulus and maintaining low interest rates props the markets up, withdrawing that liquidity and raising interest rates should have the exact opposite effect–and of course it has.

The Fed followed up with a 0.5% and 0.75% short term interest rate hike in May and June respectively, bringing the short-term rate to around 1.5%. During the June meeting, The Fed telegraphed that a further 0.5% or 0.75% interest rate hike could be forthcoming in July (and future months) if inflation doesn’t ease in the coming month. Of course, with inflation running over 8%, The Fed, with short term interest rates around 1.5%, is still woefully behind the curve. Many pundits and critics want them to move much faster to tame inflation.

Low interest rates (near 0% for over two years) represent “cheap money” to individuals and companies, encouraging investment, spending, borrowing, and of course speculation. All of that tends to make for an overheated economy, pushing prices higher. Raising interest rates tends to curb the demand for capital and overall spending, thereby reducing pressure on the supply of goods and services, and in turn, reducing pressure on prices. But by doing so, The Fed risks pushing the economy into a recession.

Recession or Soft Landing

The Fed has acknowledged that lifting interest rates may curb consumer and corporate demand enough to push the economy into a recession. Fact is, it’s possible that we’re already in a recession but don’t know it yet.

The textbook definition of a recession is at least “two consecutive calendar quarters of negative gross domestic product or GDP.” For the first quarter of 2022, the economy did register a negative GDP of 1.3%, and the second quarter could potentially register a similar small negative GDP. As of Friday June 16, the Atlanta Federal Reserve lowered GDP estimates for the 2nd quarter to about 0%, which means that it could easily turn negative by the end of the quarter, putting us into a an official recession.

Regardless of how the 2nd quarter plays out, textbook recession or not, I would expect that any recession would be another mild or short one (like the short-lived COVID recession of 2020) as we try and squeeze out much of the excesses brought on by the post-COVID over-stimulus. While you’re likely to be bombarded (and scared witless) by the news media about how the economy has officially fallen into a recession, it remains to be seen how long and how bad it might get. With housing and employment still strong, and corporate earnings holding steady, (albeit weakening somewhat with everything else), the recession should prove to be mild or moderate in my opinion.

What To Do Now

The market is currently in what I would characterize as “no-man’s land”. That’s to say that it’s too late to sell and yet probably too early to buy. As mentioned above, we have the potential to visit the 50% retracement level of S&P 500 at 3,500, 5% lower from here. But the selling was so intense last week, that could be considered somewhat exhaustive, or capitulatory as some refer to it in the business. While bad things tend to get worse in the markets before they get better, the proverbial rubber band to the downside is firmly stretched, meaning that a strong snapback rally could start as early as tomorrow, if not later this week or next.

In a mid-term election year, we tend to see a summer rally from late June into mid-July, with weakness or sideways movement persisting throughout the August-October period. But post-election, a year-end relief rally into the spring tends to be strong. So unfortunately, any relief rally in June/July may prove fleeting, with much better probabilities for a long-term rally coming in the 4th quarter. Of course, this is all crystal ball prognostication, relying on history to project future returns. This should not be relied on to make investment/portfolio decisions.

So, what about nibbling at stocks and stock funds (and even bonds) with the market down so much? While dollar cost averaging over time has a successful track record, the key is your own personal discipline to continue investing at regular intervals and knowing that it may take months or years to become profitable on new buys, especially if this market doesn’t find a bottom until late this year or next.

Those who bought in mid-2008 thinking that the bottom was in found out that they had to endure another 30% drawdown until the ultimate bottom in March 2009. In the end, this all turned out great for long term holders, albeit with a little pain.

If you are confident that you won’t sell everything if the market continues lower and reach your own capitulation point, there’s nothing wrong with nibbling on names that have come down to attractive levels. Personally, I prefer to see signs of strong demand returning from large institutions, something that is still absent at these levels. The path of least resistance, as of today, is unfortunately lower, but that could easily change in a day or two of strong buying.

For our client portfolios, we came into the 2nd quarter with one of our lowest allocations to stocks and bonds in years. We continue to be hedged with cash, stock options and bear market funds, and we continue to harvest profits and raise cash. If we see further weakness and no return of demand from institutions, we will further increase our hedges and continue to sell underperforming positions into any rallies that “peter out” in short order.

If you find yourself stuck in positions that no longer meet your initial criteria for buying them in the first place, consider using upcoming rallies to sell them (even at a loss) and upgrade your portfolio with better performing companies at the right time. Instead of big bites, take little nibbles, and keep in mind that bear market rallies are very good at sucking in investors and convincing them that the selloff is over, only to roll over and make lower lows. This is not a recommendation to buy or sell any security.

No one knows how deep the market will pull back. Have we seen the lows, or do we have some ways to go? I personally think we may have seen the worst of it, but that’s just a gut feeling. That doesn’t mean that I believe that the sell-off is over. Similarly, we have no idea if the next rally will mark the bottom of this pullback or just be another “suckers’ rally”.

In the end, these somewhat painful periods always end, paving the way for a new long-term uptrend (a.k.a., a bull market). As I always echo, investing in the stock market is great for long term returns, as long as you don’t get scared out of it at the wrong time. After all, enduring volatility is the price we pay for outsized long-term returns. Be patient and stay small with buys to keep your risk in line with your own tolerance.

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.

What’s Going on in the Markets May 8, 2022

It was another down week in the stock markets, which, under the surface, was worse than the Dow Jones Industrial Average and S&P 500 indexes being down only about 0.25% might have suggested. Volatility continues to rule the markets daily as investors and traders try to discount the effects of inflation, interest rate hikes, a raging war, and the possibility of a recession in the coming months.

Speaking of interest rate hikes, the Federal Reserve (The Fed) met last week and raised short-term interest rates by 0.5% (bringing them to 0.75%-1.00%). The Fed signaled that more 0.5% interest hikes were likely coming and also mentioned that single day 0.75% hikes were not being considered. Although the markets breathed a sigh of relief on Wednesday and rallied about 3% from the day’s lows, that rally was short-lived as the markets gave it all back and more on Thursday and Friday.

As of Friday’s close, the S&P 500 index is down about 13.5%, while the harder-hit tech-heavy NASDAQ is down about 22.3% year-to-date. Those figures, however, don’t reflect the level of carnage under the surface, where some growth stocks are down as much as 80% from their prior peaks. Strength in the markets is found in energy stocks (where oil prices continue to float above $100 a barrel) and defensive stocks (consumer staples, some healthcare, and utilities).

Even bonds, long known to provide ballast to stocks, are down about 11% year-to-date and have not held up their end of the bargain. Bonds are having one of their worst starts to the year since the 1970s. Even if you’re hiding out in 1–3 year short-term treasury bonds, you’re still down about 3.1% since the beginning of the year. The typical 60/40 (stock/bond) portfolio has provided no shelter from the recent market storm.

When you see both stocks and bonds down in tandem, the usual culprit is an inflationary environment. Last month’s government report on inflation, the Consumer Price Index (CPI), showed inflation rose 1.2% in March, translating to an annualized rate of 8.5%. This coming Wednesday, we get the read on April inflation, which should see inflation easing from March levels (based on reports of declining used car prices, lower demand for homes, and supply chain improvements).

The Fed has two core mandates as its mission: 1) keep unemployment low and 2) maintain price stability.

At this point, The Fed has no choice but to raise interest rates to try and tame the inflation beast. Unfortunately, raising short-term interest rates has the side effect of slowing economic activity because capital becomes more expensive for both consumers and companies, thereby forcing a slowdown of discretionary purchases and capital improvements (and stock buybacks, which buoy the markets). We are already seeing a slight easing in housing market pressures as 30-year mortgage rates tick above 5%.

Inflation at the current rates is simply not tenable, and therefore The Fed must do what it can to keep the prices of goods and services at prices that consumers can afford.

Further taming of the inflation beast with short-term interest rate hikes can sometimes cause such a slowdown in the economy that we see negative growth in the gross domestic product (GDP), as was reported in the 1st quarter of 2022 when GDP unexpectedly contracted by 0.4% (which is an annualized rate of 1.4%).

As of the end of the 1st quarter, we had only experienced a single 0.25% short-term interest rate hike by The Fed, so that was not the proximate cause of the decline in GDP. More likely, the side effects of the ongoing war in Ukraine, a complete lockdown in parts of China because of COVID resurgence, and inflation worries all weighed on the economy in an otherwise environment of robust consumer demand.

The definition of an economic recession is two consecutive quarters of contracting GDP, so 2nd quarter 2022 GDP is pivotal in determining whether we’re already in an economic recession. Perhaps that’s what has the markets worried.

Also on the economic front, both the Institute for Supply Management’s (ISM) Manufacturing Index and the ISM Services Index remained at high levels last month; however, there is some weakness developing under the surface. The ISM Manufacturing Index has fallen in five of the last six months, while new orders for the services sector fell to a 14-month low. At the same time, prices have remained stubbornly high in both indexes, which raises the possibility of economic stagflation (inflation + slowing economy) in the coming months.

What About Now?

While the markets continue their correction (pullback), we have continued to get more defensive in our client portfolios by selling more (underperforming) positions, adding to our hedges, and tightening up our option selling. Unfortunately, in a rising volatility environment, the fruits of our option selling labor don’t begin to show up in client portfolio results until after the volatility subsides, or those sold options expire. That doesn’t mean we won’t continue to allocate to those strategies to reduce portfolio risk, but in the short term, they may not display the intended positive portfolio effects.

While I don’t have a working crystal ball, I’ve seen little evidence that the volatility is about to subside anytime soon. Though the markets are oversold (stretched to the downside) on a short-term basis, we have not seen any bounces that have lasted longer than a day or two, at least not since late March. We are certainly overdue for a robust bounce that lasts at least a few weeks or months, but I don’t see any evidence to believe that we’re at a durable long-term bottom yet.

Therefore, this back-and-forth choppy action may continue until after the mid-term elections, as is typical for this part of the presidential cycle. We may also need to shake out more weak hands in the short term and get to some level of capitulation or panic in order to get a sustainable rally.

One contrary indicator, investor sentiment about the markets, is at some of the lowest levels–some levels on par with sentiment during the great financial crisis in 2007-2009 and the COVID crisis, hinting that investors are not very exuberant about investing in the markets. Another contrary indicator, mutual fund flows, shows that investors of late are cashing out of stocks in recent weeks, which means at some point, many will be forced to buy back their stocks in the near future.

If you’re not a client of ours, I hope you have taken some action with your portfolio during the prior market rallies, to reduce your overall risk and exposure to the stock market. Whether selling some underperforming positions, buying some bear market funds, or just hedging your portfolio in one way or another, figure out a way to reduce your overall portfolio risk. Don’t wait until the market is down a lot before taking some action. You want to have some cash on hand to pick up some “bargains” once the market resumes its uptrend.

If you have not, or if you still feel overexposed, you should consider doing so during the next market rally to bring your portfolio more in line with your own personal risk tolerance. This is especially true if you find yourself worried about your investments more than usual these days. Remember, no one can control what the market does, but you and only you can control the risk you’re taking and the amount of the loss you wish to sustain. If you’re picking up anything on this downturn, keep it small and expect that you’ll have to wait some time to become profitable on these positions. Disclaimer: None of the foregoing should be construed as investment advice or a recommendation to buy or sell any security. Please consult with your own financial advisor or talk to us if you need help.

In a rising interest rate environment where inflation is not yet under control, and where The Fed is now a net seller of bond assets (instead of a buyer), stocks will have a hard time making it back to old highs, not to mention making new ones. While the 13-year-old bull market may not be finally dead, I don’t see this environment as friendly to investing as it has been in the recent past. Don’t assume that the “beach-ball” market that absorbed all manner of “meme stocks”, special purpose acquisition companies (SPACs), Ponzi stocks, a flood of IPOs, and additional stock offerings is going to come roaring back, because I don’t believe that it will anytime soon. Remember, if your favorite stock is down 50%, you need it to double just to get back to even. I don’t think you can count on that anytime soon either.

There’s a saying in the investing world that most have heard: “Don’t Fight The Fed.” That means when The Fed is accommodative with low-interest rates and is actively providing liquidity to the markets (as they mostly have for the past 13 years), you’re essentially investing with the wind at your back. In that environment, you want to be a net buyer, not a net seller of securities.

If you believe that saying is true during the accommodative periods, then trying to fight the Fed when they are withdrawing liquidity and raising interest rates and insisting that the market should go up in the face of those headwinds would not make much sense during the non-accommodative period we’re experiencing right now.  A time of Fed accommodation will return at some point but be patient and cautious with new investments until then.

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.

What’s Going on in the Markets February 27, 2022

Since our last post on What’s Going on in the Markets on January 30, 2022, the market has seen a flurry of volatility trying to come to grips with higher than expected inflation, the Russian invasion of Ukraine, and the coming interest rate increases by the Federal Reserve. Our hearts go out to those suffering in Ukraine because of yet another unnecessary war.

Since the beginning of the year, while the S&P 500 Index has seen a maximum decline of approximately 11% on a daily closing basis, the carnage under the surface in many stocks and sectors of the markets has been far worse with some stocks down more than 75% on the year. In this post, we’ll look at the factors that may call for further declines or for a coming rally.

The Good

We’ve previously written about how markets undergo a pullback greater than 10% on average every 10-12 months, also called a correction. Therefore, the current correction, which was long overdue by the time it arrived in January, is part of the normal course of ebbs and flows in the stock markets. No one really knows if a correction will devolve into a full-blown bear market until after the fact (a bear market is a decline of 20% or more from the last market peak). While bear markets tend to be harbingers of coming recessions, they don’t always forecast them with 100% accuracy (nothing does).

Historically speaking there are no bells rung at the start of a bear market. In fact, market tops are notoriously difficult to identify except in hindsight, as they are often quite volatile and take months to unfold. The good news is that we’ve been preemptively defensive in our portfolio decisions. The bad news is that a few bear market warning flags are starting to sequentially wave and resemble some of the ones we’ve seen in the most significant bull market tops in history. But it’s not yet a sign to sell everything.

Corporate earnings are the primary driver of the stock market. Simply put, the better the earnings, the higher the market can go. Towards that end, the corporate earnings reports for the 4th quarter of 2021 were better than expected from a revenue and net income perspective, and corporate guidance (forecasting) relating to 1st quarter 2022 earnings were equally positive. Earnings guidance for the rest of 2022 tended to be even more positive and points to a reacceleration of the economy in the back half of the year. That tends to indicate that a recession is off the table, which is consistent with my beliefs and would stave off a bear market.

From a COVID-19 standpoint, since we’ve tamed the Omicron variant, the country is starting to plan for a return to a bit of normalcy with the relaxing of masking requirements around the country and less onerous vaccination mandates. This alone ought to put a bid into the travel, entertainment and leisure industry, as pent-up demand picks up steam and drives further spending. This also adds to the “no recession on the horizon” narrative.

The joblessness and employment figures are surprisingly to the good side, with unemployment levels lower and jobs numbers steadily improving. And employees and new hires are seeing higher wages, which again, will drive higher spending that will stave off a recession (but unfortunately, also drive inflation higher).

While the effects of the Russian invasion of Ukraine may have some impact on the delivery timeline of various goods and services, the supply chain constraints that plagued the economy in 2021 seem to be subsiding, removing some inflationary pressure, and allowing more deliveries of materials and finished goods to factories and consumers respectively.

The Bad

With one trading day left in the month, the S&P 500 Index is down about 3% for the month and down 8% from the year-end 2021 close. While totally within the realm of normal expected volatility, especially for a mid-cycle election year, it’s never fun to experience that kind of decline. That’s because, as mentioned above, many sectors and stocks have been hit far harder. Fortunately, the last couple of days saw a robust bounce in the markets from the depths of fear at the start of the invasion of Ukraine.

Inflation continues its domination of headlines as the last consumer price index clocked in at an annualized rate of 7.5% for January. Energy prices continue to rage higher as we saw oil a touch above $100 a barrel overnight last Thursday as news of the Ukraine invasion started to hit the headlines (the price of oil settled slightly under $92 at Friday’s close, but is spiking again in the Sunday overnight futures market). Food and commodity prices don’t seem to have found a ceiling yet. While some easing of inflationary pressures is expected as supply chains get back to normal and as jobs get filled, it won’t be enough to stave off interest rate hikes by the federal reserve, which are needed to keep inflation in check. I believe that we may have seen the worst of the inflation fears in January.

Speaking of interest rate hikes, estimates vary widely as to how many hikes the federal reserve will have to implement to tame the inflation beast (economists estimate between three and nine 0.25% hikes in 2021 alone). Even if we get eight 0.25% hikes this year, which I consider unlikely, we’ll still be at a 2% federal funds rate, which is quite accommodative for the economy and is generally still quite favorable for the stock market. Unfortunately, higher interest rates have a negative impact on bond prices, which have not yet found a footing this year either (but haven’t collapsed either).

Investor sentiment/psychology (feelings about the stock market) and consumer confidence are somewhat worrisome as they continue to remain moribund in the face of an economy that’s firing on all cylinders and a job seekers’ market that puts them somewhat in control (versus employers) and favors continued robust spending. Highly confident consumers tend to spend more, which drives the economy.

There is convincing evidence today that housing prices are in bubble territory. This carries strong implications for financial markets and the economy given the importance of housing to consumers’ views of their personal balance sheets. Unlike the 2005 Housing Bubble, which was largely predicated on subprime lending and credit default risk, today’s bubble has far more to do with affordability and interest rate risk. Mortgage rates have been suppressed over the past decade by the Federal Reserve’s ultra-accommodative monetary policies, including direct purchases of trillions of dollars in mortgage-backed securities and near-zero interest rates.

Mortgage rates dropped to a record low of 2.7% in early 2021 after the Fed threw the proverbial kitchen sink at the economy in response to the pandemic. However, the recent rise in long-term interest rates, along with the Federal Reserve’s decision to taper their asset purchases, have caused mortgage rates to spike back to 3.7% – the highest level in nearly two years. The combination of rising rates and rising prices has made the average mortgage payment on the same property approximately 30% more expensive than just a year ago. Monitoring the state of the housing market will be crucial in the months ahead as the Federal Reserve is due to begin tightening monetary policy as discussed above.

The Ugly

The Russian invasion of Ukraine is without a doubt an ugly, if not a well telegraphed development. If there was a wild card for the world economic recovery from the pandemic, it’s this–which has the possibility of derailing the recovery by disrupting supply chains and the flow of essential commodities from the region. Economic sanctions unfortunately tend to affect citizens more than the leaders they target, and also have an indirect adverse effect on the countries imposing them. Wars are of course unpredictable, so predicting the outcomes or effects is crystal ball type of speculation.

As the war stakes are raised, so too are the risks to the markets. If calmer heads prevail and escalation to the unthinkable can be avoided, then this should be another one of those bricks in the proverbial walls of worry of the stock markets. A protracted war that draws in other countries will lead to a market that no doubt will sell first and asks questions later.

However, one important historical insight is that most geopolitical crises or regional conflicts do not have a negative long-term impact on the stock market. In the few instances where geopolitical events have weighed on the market, it has been a result of either a broad-based global military conflict or a rise in energy prices (inflation) that puts upward pressure on U.S. interest rates (monetary policy). Of the last eleven crises/conflicts leading to war, only four of them led to a decline of 20% or more in the S&P 500 Index.

The current Russia-Ukraine conflict is likely to cause even higher energy prices, yet at the same time, might reduce the possibility of a full 0.50% rate hike from a concerned Federal Reserve in March.

The biggest concern from fighting a protracted war is a possible global slowdown, which forces us into a recession. Should that happen, I imagine it will be mitigated by a slowing of interest rate hikes and perhaps monetary stimulus. I consider this scenario unlikely at this time.

Now What?

We continue to expect volatility during this mid-term election year and remain cautious and defensive in our positioning. A deeply oversold market resulted in a big bounce on Thursday and Friday of last week, but the escalation in the rhetoric, a worsening of war tactics and increasing economic sanctions over the weekend are likely to trump any oversold markets, and we could see a big give-back of the gains of the last two days come Monday, the last trading day of February. The futures markets on Sunday night portend a very weak open for Monday morning.

There is no doubt that there is a higher-than-normal degree of risk in the market today, and there has already been a significant amount of damage under the surface.  While the S&P 500 Index is currently only 8% off its January high, virtually half of all S&P 500 stocks (and an estimated 80% of NASDAQ stocks) are already down over 20% from their highs.

The jury is out on whether this will be a protracted correction or a major bear market. However, we know that every bear market started out as a pullback, some pullbacks led to a correction, some corrections led to a small bear market, and every big bear market started out as a small bear market. And that makes the next 60-90 days perhaps the most critical in this market cycle stretching back to its start in 2009 (excluding the COVID-19 crash).

Like everything else in life, there is no crystal ball when it comes to navigating the eventual end of a market cycle. Rather, a disciplined assessment of the weight of the evidence allows us to proactively position client portfolios to be defensive when it really matters. Going forward, we are prepared to further increase portfolio defenses depending on how the events in the market unfold. Using options, inverse funds, reducing under-performing positions and harvesting profits are all ways we can reduce client portfolio risk without necessarily exiting the markets (Disclaimer: none of this is a recommendation to buy or sell any securities).

“In the end, navigating a [probable] bear market is not about putting your money under a mattress and waiting for the sky to fall. Instead, the focus should be on proactively managing risk to carefully navigate a wide range of outcomes and positioning oneself for that next great buying opportunity.”-James Stack, InvesTech Research

No doubt these can be scary times for your hard-earned nest egg, and no one enjoys giving back a chunk of market gains. But as we’ve said before, the best way to profit from the stock market is to not get scared out of it. Enduring volatility is the price we pay for the outsized gains we get from investing in the stock market, but if you find yourself losing sleep over your portfolio, talk to your financial adviser (or contact us) so you’re invested in a portfolio that has the right amount of risk for your personal temperament.

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.

Source: InvesTech Research

What’s Going on in the Markets January 30, 2022

With only one trading day left in the month, this January has seen the worst start to the year in the stock markets since 2008. Down just a tad under 10% year-to-date, after a stellar and steady 2021, could the auspicious start in the S&P 500 index portend a poor 2022 for the markets? After all, a popular market aphorism is “as January goes, so goes the rest of the year”.  Anyone who knows me well knows that I don’t ascribe much value to these popular sayings.

Much of the recent market volatility can be attributed to: 1) angst over COVID-19 variants; 2) worries about a federal reserve that has all but telegraphed 2-4 interest rate hikes in 2022; 3) the suspension of monetary stimulus (to combat inflation); 4) the absence of any significant fiscal stimulus expected from Washington; and 5) concerns over a potential Russian incursion into the Ukraine.

In this write-up, I’ll try to explain my viewpoint of what is going on in the economy and markets, and whether I think we’re heading for a much deeper pullback in the markets, or perhaps an economic recession.

Pullbacks, Corrections and Bear Markets

Enduring volatile markets is the price we pay for outsized returns that we ultimately earn for risking our money in the stock markets. Why even bother? Because cash and savings accounts pay us nothing, and bonds, which on average yield low single digit annual returns, ultimately lost a little money in 2021. Simply put, we need an alternative to stashing our money under the mattress. That’s especially true at a time when inflation is finally rearing its ugly head in a higher-than-expected way.

We need to invest in a way to at least overcome the depreciating effects of inflation on the buying power of our cash. Of course, we also need to be adequately compensated for taking the risk of investing in the stock markets.

In the media, you’ll hear about pullbacks, which is essentially any decline in prices of less than 10% from the last peak in the index, fund, or stock. Next, you’ll hear about a correction, which is a decline of 10%-19% in prices from the last peak. Finally, a bear market is a decline of 20% or more from the last peak.

2021 was such a smooth and steady uptrending year, where we barely had a couple of 5% pullbacks. By comparison, we generally experience between one and three 5% pullbacks a year. 2021 had no corrections, although we generally get one every 10-12 months. The last bear market we experienced came in February-March 2020 in the form of a 35% decline from peak to trough in the S&P 500 index, attributable to fears over COVID-19. We generally see a bear market every 3-7 years on average.

It seems obvious and unnecessary to state that the stock market is truly a “market of stocks”. Then why even say it? Because to understand what leads to pullbacks, corrections, and bear markets, you must drill down into the details of the indexes and see what’s really happening with individual stocks.

Despite an obvious uptrend in the indexes in 2021, digging into the details, you could see that there was trouble brewing under the surface. The number of uptrending stocks (stocks going higher) peaked in February 2021. So did the number of stocks making new 52-week (one-year) highs. At the same time, the number of stocks making 52-week lows bottomed and turned upward. A truly healthy market does the opposite of all this. But in fairness, after a very strong finish to 2020, the market was overdue in 2021 to take a “rest”.

In stock market parlance, we call the number of uptrending stocks relative to downtrending stocks, and the ratio of stocks making 52-week highs relative to those making 52-week lows, components of “market breadth”.

For most of 2021, despite the stock market indexes making new highs on a regular basis, it was doing so with fewer and fewer stocks participating. An estimated 10%-15% of all stocks, which were quite strong, were masking weakness in the other 85%-90% of stocks. Small capitalization stocks, which make up the largest sub-segment of the stock market (in terms of number of stocks, not company size), peaked in March 2021 (note that small stocks attempted and failed in a rally attempt in November 2021).

All throughout 2021, we also observed more and more stocks making 52-week lows, and fewer and fewer making 52-week highs. Many stocks were down 20%-70% or more from their peaks, and those new low counts were increasing almost daily. Some COVID related and stay-at-home stocks which were the heroes of 2020 were being smashed. How can that be? After all, we were still making new market index highs on a regular basis throughout the year.

Without going into a long-detailed explanation about the structure of market indexes, let’s just say that the biggest companies such as Apple and Microsoft (called large or mega capitalization stocks) have the biggest effects on the indexes, even if they are smallest in number. That’s how a cohort of 20-25 stocks could fool you into thinking that all was going great in the markets. Dig deeper–and you saw healthcare, industrial and communications stocks deteriorate as the year wore on.

If you wondered why your diversified portfolio didn’t return anywhere near the returns on the indexes, the above partially explains it. If you didn’t own enough of the chosen few outperforming stocks, your portfolio no doubt underperformed the market averages. That’s called stock investing for the long term, and it’s typical of many periods in the stock markets.

You’ll rarely if ever hear about the deterioration of market breadth on the evening news; you’ll only hear about new record highs in the indexes. Now you know a little better.

Pluses and Minuses

What does this mean for the market going forward? Are we headed for an economic recession? A bear market? Another double-digit return year? I’ll first discuss the pluses and minuses and then tell you what I see when I consult my broken crystal ball for the rest of the year.

Pluses

  1. The economy is quite strong and continues to exhibit growth, with estimates of 3%-4% gross domestic product growth expected for 2022. Before COVID-19, our economy was growing at an annual rate of 2%-3%, but due to unprecedented stimulus, we have temporarily skewed the economic picture. I would expect the economy to return to normal levels of growth in 2023.
  2. The job market continues to be robust and “tight”. Many more jobs are going unfilled than at any time in recent history, and that portends good starting wages for those looking for work. Companies that are expecting a recession would not be increasing posts for new and unfilled positions as they are right now. Higher wages mean that employees have more money to spend on goods and services, keeping upward pressure on the economy.
  3. Earnings estimates for companies, which are the primary driver of stock market returns, continue to impress and increase over 2021 levels. Consumers are still spending strongly.
  4. Many experts believe that the Omicron variant of COVID is the “swan song” of the disease, and that by mid-2022, the pandemic will be just another virus that is a part of our daily lives.
  5. Traffic, travel, hospitality as well as office occupancy are slowly showing signs of returning to pre-pandemic levels in many major cities around the world.
  6. Supply chain disruptions are easing around the world, taking inflationary pressures down with them.
  7. Used car prices, a leading contributor to inflation, could be easing as semi-conductor chip production ramps up and finds its way into automakers’ cars waiting for delivery on their lots.
  8. Consumer spending and demand for goods and services continues to be robust. Demand for travel and leisure services, considering the potential fading of COVID, can only be expected to increase.
  9. The recent market sell-off has shaved off some speculative fervor from the markets, and the market is oversold on many metrics, which portends at least a short-term bounce (which may have started on Friday, January 28th).

Minuses

  1. The strength in the economy could be hurt in the 1st quarter of 2022 due to the Omicron variant disrupting production, increasing absenteeism, and reducing employee productivity.
  2. Job growth and employee shortages contribute to wage inflation, which is the leading contributor to overall inflation. This will continue to pressure the federal reserve to increase interest rates to cool the economy. Higher interest rates reduce corporate earnings via higher interest expense, and implicitly lead to reduced stock price multiples (price-earnings ratio).
  3. Although the recent sell-off has somewhat cooled the speculative fever in the stock markets, initial public offerings, special purpose acquisition companies, cryptocurrencies and non-fungible tokens, relative excess enthusiasm around speculation remains.
  4. Housing prices may be in a bubble. With a continued short supply of available housing, this could also continue to exert upward pressure on housing prices for some time to come.
  5. Monetary and fiscal stimulus, the prominent catalysts in one of the quickest recoveries from one of the shortest recessions in history (2020), looks to be notably absent given Congress’ failure to pass the Build Back Better stimulus bill last year. The likelihood of passing significant alternate stimulus legislation in a mid-term election year seems unlikely.

My Broken Crystal Ball Expectations

Normally, I try and avoid speculation about the future of the markets and economy, because I’ll just be guessing like anyone else.  But given that I manage million-dollar portfolios, and that I must make educated guesses about stocks, the markets, and the economy every day, I provide my thoughts for what they’re worth.

The weight of evidence points to a continuation of robust economic conditions that will lead to higher corporate profits. In other words, I don’t believe that 2022 will be the year we experience an economic recession.

This should lead to a stock market that’s higher at year-end than it is today. How much higher, if I had to guess, is probably less than 10%-12% from where we are today. That would mean we probably won’t make new highs in the markets for the rest of the year, which obviously means that I don’t think we’ll have a bear market this year.

Given uncertainty and angst over federal reserve short-term interest rate hikes and the ultimate lingering effects of COVID, I have near conviction that the volatility in the markets for 2022 will persist. That’s not saying much if I’m honest, because volatility is always expected in the markets. What I really mean is that the relative calm of 2021 won’t be repeated in 2022. But with volatility come opportunities to make new investments in stocks that become somewhat more fairly priced or undervalued.



As for the short term, Friday January 28th saw a robust market bounce after a very tumultuous week. While the bottom of this correction may have been seen at the lows made on Monday January 24th, we’ll only know that in hindsight in a few weeks. My best guess is that there may be one more re-test of that day’s low, but the real test right now is the robustness of the current bounce. If the recovery is solid and strong, then we may have seen the short-term lows for this correction.

Regardless, I don’t believe this means a straight up market and a full recovery of the immense damage done to tons of growth stocks, many of which won’t get back to old highs anytime soon, if ever.  If you’ve been nibbling on stocks into this decline, be ready to withstand a lot of back-and-forth action that will frustrate both the bulls (optimists) and bears (pessimists). “The secret to success in stocks is to not get scared out of them” – John Buckingham

If you’re stuck with poor performing investments, especially when you’re sitting on large losses, ask yourself whether it makes sense to sell them into the strength that any upcoming/current bounce ultimately provides. Don’t think that they’ll eventually and automatically come back, because many won’t. In general, I have a rule: if a long-term investment underperforms for 1-2 years after I buy it, it’s time to consider cutting it. Don’t be too hard on yourself about it; just be ruthless in letting go of stocks that may have their best days behind them. Deploy the cash in better opportunities. If you found yourself too heavily invested coming into this decline, you may want to take advantage of the bounce to lighten up your exposure and take some risk off the table. Disclaimer: This is in no way investment advice or a recommendation to buy or sell any securities; please consult with your financial adviser (or us) for help.

For our client portfolios, we remain invested along with our portfolio hedges, which we adjust to changing market conditions. In addition, by using options to dampen volatility, reduce overall risk and generate income, we are well positioned to profit from whatever the year decides to throw at us.

For 2022, I believe that after 21 months of unusually calm and one way upward markets, this year will prove to be a more “normal” year with two-way market action, and likely single digit positive returns. But my crystal ball is still broken, so take this forecast for what it’s worth.

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.

‘Tis the Season to Be Thinking about Charitable Giving

With the holiday season upon us and the end of the year approaching, we pause to give thanks for our blessings and the people in our lives. It is also a time when charitable giving often comes to mind. The tax benefits associated with charitable giving could potentially enhance your ability to give and should be considered as part of your year-end tax planning.

Tax deduction for charitable gifts

If you itemize deductions on your federal income tax return, you can generally deduct your gifts to qualified charities. This may also help potentially increase your gift.

Example(s): Assume you want to make a charitable gift of $1,000. One way to potentially enhance the  gift is to increase it by the amount of any income taxes you save with the charitable deduction for the gift. At a 24% tax rate, you might be able to give $1,316 to charity [$1,000 ÷ (1 – 24%) = $1,316; $1,316 x 24% = $316 taxes saved]. On the other hand, at a 32% tax rate, you might be able to give $1,471 to charity [$1,000 ÷ (1 – 32%) = $1,471; $1,471 x 32% = $471 taxes saved].

However, keep in mind that the amount of your deduction may be limited to certain percentages of your adjusted gross income (AGI). For example, your deduction for gifts of cash to public charities is generally limited to 60% of your AGI for the year, and other gifts to charity are typically limited to 30% or 20% of your AGI. Charitable deductions that exceed the AGI limits may generally be carried over and deducted over the next five years, subject to the income percentage limits in those years.

For 99% of the population, this limitation is never a problem.

Nonetheless, for 2021 charitable gifts, the normal rules have been enhanced: The limit is increased to 100% of AGI for direct cash gifts to public charities. And even if you don’t itemize deductions, you can receive a $300 charitable deduction ($600 for joint returns) for direct cash gifts to public charities (in addition to the standard deduction).

Make sure to retain proper substantiation of your charitable contribution. In order to claim a charitable deduction for any contribution of cash, a check, or other monetary gift, you must maintain a record of such contributions through a bank record (such as a cancelled check, a bank or credit union statement, or a credit-card statement) or a written communication (such as a receipt or letter) from the charity showing the name of the charity, the date of the contribution, and the amount of the contribution. If you claim a charitable deduction for any contribution of $250 or more, you must substantiate the contribution with a contemporaneous written acknowledgment of the contribution from the charity. A copy of a canceled check is no longer enough to substantiate your deduction. If you make any non-cash contributions, there are additional requirements.

Year-end tax planning

When making charitable gifts at the end of a year, you should consider them as part of your year-end tax planning. Typically, you have a certain amount of control over the timing of income and expenses. You generally want to time your recognition of income so that it will be taxed at the lowest rate possible, and time your deductible expenses so they can be claimed in years when you are in a higher tax bracket.

For example, if you expect to be in a higher tax bracket next year, it may make sense to wait and make the charitable contribution in January so that you can take the deduction next year when the deduction results in a greater tax benefit. Or you might shift the charitable contribution, along with other deductions, into a year when your itemized deductions would be greater than the standard deduction amount. And if the income percentage limits above are a concern in one year, you might consider ways to shift income into that year or shift deductions out of that year, so that a larger charitable deduction is available for that year. A tax professional can help you evaluate your individual tax situation.

If you want to “turbo-charge” your charitable deduction, consider donating appreciated securities (stocks, bonds, mutual funds, etc.) Not only do you get a deduction for full fair market value of the security, you also escape capital gain taxes on the appreciation you donated. If you want to donate securities that have gone down in value, it’s always better to sell them first, capture the capital loss, then donate the cash (there’s no inherent advantage in donating depreciated securities).

If you give more than $1,000 a year to charity, it may be time to consider a Donor Advised Fund (DAF). A DAF allows you to “bunch” your charitable deductions to allow you to itemize deductions when you might otherwise only qualify for the standard deduction. By funding the DAF with an amount large enough to put you over the standard deduction, you can make charitable “grants” over several years while getting a full deduction in the year that you fund the DAF. Keep in mind that money transferred into a DAF can never be removed, and the only beneficiaries of the DAF are qualified Section 501(c)(3) charities. You can set up a DAF with most major brokers at no cost, and some have no minimums. Talk to us if you’d like more information about setting one up.

A word of caution

Be sure to deal with recognized charities and be wary of charities with similar-sounding names. It is common for scam artists to impersonate charities using bogus websites, email, phone calls, social media, and in-person solicitations. Check out the charity on the IRS website, irs.gov, using the “Tax Exempt Organization Search” tool. And never send cash; contribute by check or credit card and be wary of those asking for cash donations, unless perhaps they’re standing in front of a red kettle.

If you would like to review your current investment portfolio or discuss charitable giving or 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.

It’s Employer Open Enrollment Season: Making Benefit Choices That Work for You

Open enrollment is the window of time when employers introduce changes to their benefit offerings for the upcoming plan year. If you’re employed, this is your once-a-year chance to make important decisions that will affect your healthcare choices and your finances. This is the critical time to, at a minimum, consider whether changes in your benefit options are needed.

Even if you are satisfied with your current health plan, it may no longer be the most cost-effective option. Before you make any benefit elections, take plenty of time to review the information provided by your employer. You should also consider how your life has changed over the last year and any plans or potential developments for 2022.

Decipher Your Health Plan Options

The details matter when it comes to selecting a suitable health plan. One of your options could be a better fit for you (or your family) and might even help reduce your overall health-care costs. But you will have to look beyond the monthly premiums. Policies with lower premiums tend to have more restrictions or higher out-of-pocket costs (such as copays, coinsurance, and deductibles) when you do seek care for a health issue.

To help you weigh the tradeoffs, below is a comparison of the five main types of health plans. It should also help demystify some of the terminology and acronyms used so often across the health insurance landscape.

  • Health maintenance organization (HMO). Coverage is limited to care from physicians, other medical providers, and facilities within the HMO network (except in an emergency). You choose a primary-care physician (PCP) who will decide whether to approve or deny any request for a referral to a specialist.
  • Point of service (POS) plan. Out-of-network care is available, but you will pay more than you would for in-network services. As with an HMO, you must have a referral from a PCP to see a specialist. POS premiums tend to be a little bit higher than HMO premiums.
  • Exclusive provider organization (EPO). Services are covered only if you use medical providers and facilities in the plan’s network, but you do not need a referral to see a specialist. Premiums are typically higher than an HMO, but lower than a PPO.
  • Preferred provider organization (PPO). You have the freedom to see any health providers you choose without a referral, but there are financial incentives to seek care from PPO physicians and hospitals (a larger percentage of the cost will be covered by the plan). A PPO usually has a higher premium than an HMO, EPO, or POS plan and often has a deductible.

A deductible is the amount you must pay before insurance payments kick in. Preventive care (such as annual visits and recommended screenings) is typically covered free of charge, regardless of whether the deductible has been met.

  • High-deductible health plan (HDHP). In return for significantly lower premiums, you’ll pay more out-of-pocket for medical services until you reach the annual deductible. HDHP deductibles start at $1,400 for an individual and $2,800 for family coverage in 2022, and can be much higher. Care will be less expensive if you use providers in the plan’s network, and your upfront cost could be reduced through the insurer’s negotiated rate.

An HDHP is designed to be paired with a health savings account (HSA), to which your employer may contribute funds toward the deductible. You can also elect to contribute to your HSA through pre-tax payroll deductions or make tax-deductible contributions directly to the HSA provider, up to the annual limit ($3,650 for an individual or $7,300 for family coverage in 2022, plus $1,000 for those 55+).

HSA funds, including any earnings if the account has an investment option, can be withdrawn free of federal income tax and penalties if the money is spent on qualified health-care expenses. (Some states do not follow federal tax rules on HSAs.) Unspent balances can be retained in the account indefinitely and used to pay future medical expenses, whether you are enrolled in an HDHP or not. If you change employers or retire, the funds can be rolled over to a new HSA.

Three Steps to a Sound Decision

Start by adding up your total expenses (premiums, copays, coinsurance, deductibles) under each plan offered by your employer, based on last year’s usage. Your employer’s benefit materials may include an online calculator to help you compare plans by taking factors such as your chronic health conditions and regular medications into account.

If you are married, you may need to coordinate two sets of workplace benefits. Many companies apply a surcharge to encourage a worker’s spouse to use other available coverage, so look at the costs and benefits of having both of you on the same plan versus individual coverage from each employer. If you have children, compare what it would cost to cover them under each spouse’s plan.

Before enrolling in a plan, check to see if your preferred health-care providers are included in the network.

Tame Taxes with a Flexible Spending Account

If you elect to open an employer-provided health and/or dependent-care flexible spending account (FSA), the money you contribute via payroll deduction is not subject to federal income and Social Security taxes (nor generally to state and local income taxes). Using these tax-free dollars to pay for health-care costs not covered by insurance or for dependent-care expenses could save you about 30% or more, depending on your tax bracket.

The federal limit for contributions to a health FSA was $2,750 in 2021 and should be similar for 2022. Some employers set lower limits. (The official limit has not been announced by the IRS). You can use the funds for a broad range of qualified medical, dental, and vision expenses.

With a dependent-care FSA, you can set aside up to $5,000 a year (per household) to cover eligible child-care costs for qualifying children age 12 or younger. The tax savings could help offset some of the costs paid for a nanny, babysitter, day care, preschool, or day camp, but only if the services are used so you (or a spouse) can work.

One drawback of health and dependent-care FSAs is that they are typically subject to the use-it-or-lose-it rule, which requires you to spend everything in your account by the end of the calendar year or risk losing the money. Some employers allow certain amounts (up to $550) to be carried over to the following plan year or offer a grace period up to 2½ months. Still, you must estimate your expenses in advance, and your predictions could turn out to be way off base.

Legislation passed during the pandemic allows workers to carry over any unused FSA funds from 2021 into 2022, as long as the employer opts into this temporary change. If you have leftover money in an FSA, you should consider your account balance and your employer’s carryover policies when deciding on your contribution election for 2022.

Take Advantage of Valuable Perks

A change in the tax code enacted at the end of 2020 made it possible for employers to offer student debt assistance as a tax-free employee benefit through 2025, spurring more companies to add it to their menu of benefit options. A 2021 survey found that 17% of employers now offer student debt assistance, and 31% are planning to do so in the future. Many employers target a student debt assistance benefit of $100 per month, which doesn’t sound like much, but it adds up.(1) For example, an employee with $31,000 in student loans who is paying them off over 10 years at a 6% interest rate would save about $3,000 in interest and get out of debt 2½ years faster.

Many employers provide access to voluntary benefits such as dental coverage, vision coverage, disability insurance, life insurance, and long-term care insurance. Even if your employer doesn’t contribute toward the premium cost, you may be able to pay premiums conveniently through payroll deduction. Your employer may also offer discounts on health-related products and services, such as fitness equipment or gym memberships, and other wellness incentives, like a monetary reward for completing a health assessment.

If you have an opportunity to change your life insurance, disability insurance or other perks, you may want to talk to us about how much coverage you need. Don’t miss this annual chance to review your coverage and possibly elect higher coverage.

If you would like to review your current investment portfolio or discuss employer benefit options and enrollment, 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.

(1) CNBC, September 28, 2021

Perhaps Your Last Chance before the Backdoor Closes

Among the many provisions in the multi-trillion-dollar legislative package being debated in Congress, is a provision that would eliminate a strategy that allows high-income investors to pursue tax-free retirement income: the so-called “back-door Roth IRA”. The next few months may present the last chance to take advantage of this opportunity.

Roth IRA Background

Since its introduction in 1997, the Roth IRA has become an attractive investment vehicle due to the potential to build a sizable, tax-free nest egg. Although contributions to a Roth IRA are not tax deductible, any earnings in the account grow tax-free as long as future distributions are qualified. A qualified distribution is one made after the Roth account has been held for five years and after the account holder reaches age 59½, becomes disabled, dies, or uses the funds for the purchase of a first home ($10,000 lifetime limit) or for qualified higher education expenses.

Unlike other retirement savings accounts, original owners of Roth IRAs are not subject to required minimum distributions at age 72 — another potentially tax-beneficial perk that makes Roth IRAs appealing in estate planning strategies (but beneficiaries are subject to distribution rules.)

However, as initially passed, the 1997 legislation rendered it impossible for high-income taxpayers to enjoy Roth IRAs. Individuals and married taxpayers whose income exceeded certain thresholds could neither contribute to a Roth IRA nor convert traditional IRA assets to a Roth IRA.

A Loophole Emerges

Nearly 10 years after the Roth’s introduction, the Tax Increase Prevention and Reconciliation Act of 2005 ushered in a change that relaxed the conversion rules beginning in 2010; that is, as of that year, the income limits for a Roth conversion were eliminated, which meant that anyone could convert traditional IRA assets to a Roth IRA (of course, a conversion results in a tax obligation on deductible contributions and earnings that have previously accrued in the traditional IRA.)

One perhaps unintended consequence of this change was the emergence of a new strategy that has been heavily utilized ever since: High-income individuals could make full, annual, nondeductible contributions to a traditional IRA and convert those contribution dollars to a Roth. If the account holders had no other IRAs (see note below) and the conversion was executed quickly enough so that no earnings were able to accrue, the transaction could potentially be a tax-free way for otherwise ineligible taxpayers to fund a Roth IRA. This move became known as the “back-door Roth IRA”.

Employees working for companies which had retirement plans that allowed post-tax contributions into their 401(k)’s, along with “in-service distributions”, could replicate the back-door strategy in a potentially much bigger way, which became known as the “mega-back-door Roth IRA”

Note: When calculating a tax obligation on a Roth conversion, investors have to aggregate all of their IRAs, including SEP and SIMPLE IRAs, before determining the amount. For example, say an investor has $100,000 in several different traditional IRAs, 80% of which is attributed to deductible contributions and earnings. If that investor chose to convert any traditional IRA assets — even recent after-tax contributions — to a Roth IRA, 80% of the converted funds would be taxable. This is known as the “pro-rata rule.”

Current Roth IRA Income Limits

For 2021, you can generally contribute up to $6,000 to an IRA (traditional, Roth, or a combination of both); $7,000 if you’ll be age 50 or older by December 31. However, your ability to make contributions to a Roth IRA is limited or eliminated if your modified adjusted gross income, or MAGI, falls within or exceeds the parameters shown below.

If your federal filing status is:Your 2021 Roth IRA contribution is reduced if your MAGI is:You can’t contribute to a Roth IRA for 2021 if your MAGI is:
Single or head of householdMore than $125,000 but less than $140,000$140,000 or more
Married filing jointly or qualifying widow(er)More than $198,000 but less than $208,000$208,000 or more
Married filing separatelyLess than $10,000$10,000 or more

Note that your contributions generally can’t exceed your earned income for the year (special rules apply to spousal Roth IRAs).

Now or Never … Maybe

While no one knows for sure what may come of the legislative debates, the current proposal would prohibit the conversion of nondeductible contributions from a traditional IRA (or 401(k)) after December 31, 2021. If you expect your MAGI to exceed this year’s thresholds and you’d like to fund a Roth IRA for 2021, the next few months may be your last chance to use the back-door strategy.

You can make 2021 IRA contributions up until April 15, 2022, but if the legislation is enacted, a Roth conversion involving nondeductible contributions would have to be executed by December 31, 2021.

Keep in mind that a separate five-year rule applies to the principal amount of each Roth IRA conversion you make, unless an exception applies.

In addition to eliminating the conversion of nondeductible contributions from traditional IRAs to Roth IRAs, the proposed legislation includes a similar prohibition on the conversion of after-tax 401(k) contributions (so-called mega-back-door Roth conversions), as well as other retirement-related provisions affecting those with large account balances ($10 million and higher) and high incomes (more than $400,000 for single taxpayers and more than $450,000 for joint filers).

Don’t wait until the last minute to make these contributions or conversions. Brokerage firms are extremely busy during the last half of December, and will be especially so if tax legislation is passed this year. Now is the time to be thinking about doing this if it fits within your financial plan.

If you would like to review your current investment portfolio or discuss your Roth IRA options, 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 Proposals in Congress Not as Bad as Feared

The latest tax bill advanced in Congress is notable in its absence of provisions that were expected to be “game changers” (see below). And that’s a good thing for taxpayers.

On Saturday, September 25, 2021, the Congressional House Budget Committee voted to advance a $3.5 trillion spending package to the House floor for debate. The House Ways and Means Committee and the Joint Committee on Taxation had previously released summaries of proposed tax changes intended to help fund the spending package. Many of these provisions focus specifically on businesses and high-income households.

Expect these proposals to be modified; some will likely be removed and others added as the legislative process continues. As we monitor progression through the legislative process though, here are some highlights from the previously released proposed provisions worth noting.

Corporate Income Tax Rate Increase

Corporations would be subject to a graduated tax rate structure, with a higher top rate.

Currently, a flat 20% rate applies to corporate taxable income. The proposed legislation would impose a top tax rate of 26.5% on corporate taxable income above $5 million. Specifically:

  • A 16% rate would apply to the first $400,000 of corporate taxable income
  • A 21% rate on remaining taxable income up to $5 million
  • The 26.5% rate would apply to taxable income over $5 million, and corporations making more than $10 million in taxable income would have the benefit of the lower tax rates phased out.

Personal service corporations (professionals providing services as a regular sub-chapter C Corporation, not an S Corporation) would pay tax on their entire taxable income at 26.5%.

Tax Increases for High-Income Individuals

Top individual income tax rate. The proposed legislation would increase the existing top marginal income tax rate of 37% to 39.6% effective in tax years starting on or after January 1, 2022, and apply it to taxable income over $450,000 for married individuals filing jointly, $425,000 for heads of households, $400,000 for single taxpayers, and $225,000 for married individuals filing separate returns. (These income thresholds are lower than the current top rate thresholds.)

Top capital gains tax rate. The top long-term capital gains tax rate would be raised from 20% to 25% under the proposed legislation; this increased tax rate would generally be effective for sales after September 13, 2021. In addition, the taxable income thresholds for the 25% capital gains tax bracket would be made the same as for the 39.6% regular income tax bracket (see above) starting in 2022.

New 3% surtax on income. A new 3% surtax is proposed on modified adjusted gross income over $5 million ($2.5 million for a married individual filing separately).

3.8% net investment income tax expanded. Currently, there is a 3.8% net investment income tax on high-income individuals. This tax would be expanded to cover certain other income derived in the ordinary course of a trade or business for single taxpayers with taxable income greater than $400,000 ($500,000 for joint filers). This would generally affect certain income of S corporation shareholders, partners, and limited liability company (LLC) members that is currently not subject to the net investment income tax.

New qualified business income deduction limit. A deduction is currently available for up to 20% of qualified business income from a partnership, S corporation, or sole proprietorship, as well as 20% of aggregate qualified real estate investment trust dividends and qualified publicly traded partnership income. The proposed legislation would limit the maximum allowable deduction at $500,000 for a joint return, $400,000 for a single return, and $250,000 for a separate return.

Retirement Plans Provisions Affecting High-Income Individuals

New limit on contributions to Roth and traditional IRAs. The proposed legislation would prohibit those with total IRA and defined contribution retirement plan accounts exceeding $10 million from making any additional contributions to Roth and traditional IRAs. The limit would apply to single taxpayers and married taxpayers filing separately with taxable income over $400,000,  $450,000 for married taxpayers filing jointly, and $425,000 for heads of household.

New required minimum distributions for large aggregate retirement accounts.

  • These rules would apply to high-income individuals (same income limits as described above), regardless of age.
  • The proposed legislation would require that individuals with total retirement account balances (traditional IRAs, Roth IRAs, employer-sponsored retirement plans) exceeding $20 million distribute funds from Roth accounts (100% of Roth retirement funds or, if less, by the amount total retirement account balances exceed $20 million).
  • To the extent that the combined balance in traditional IRAs, Roth IRAs, and defined contribution plans exceeds $10 million, distributions equal to 50% of the excess must be made.
  • The 10% early-distribution penalty tax would not apply to distributions required because of the $10 million or $20 million limits.

Roth conversions limited. In general, taxpayers can currently convert all or a portion of a non-Roth IRA or defined contribution plan account into a Roth IRA or defined contribution plan account without regard to the amount of their taxable income. The proposed legislation would prohibit Roth conversions for single taxpayers and married taxpayers filing separately with taxable income over $400,000, $450,000 for married taxpayers filing jointly, and $425,000 for heads of household. [It appears that this proposal would not be effective until 2032.]

Roth conversions not allowed for distributions that include nondeductible contributions. Taxpayers who are unable to make contributions to a Roth IRA can currently make “back-door” contributions by making nondeductible contributions to a traditional IRA and then shortly afterward convert the nondeductible contribution from the traditional IRA to a Roth IRA. It is proposed that amounts held in a non-Roth IRA or defined contribution account cannot be converted to a Roth IRA or designated Roth account if any portion of the distribution being converted consists of after-tax or nondeductible contributions.

Estates and Trusts

  • For estate and gift taxes (and the generation-skipping transfer tax), the current basic exclusion amount (and GST tax exemption) of $11.7 million would be cut by about one-half under the proposal.
  • The proposal would generally include grantor trusts in the grantor’s estate for estate tax purposes; tax rules relating to the sale of appreciated property to a grantor trust would also be modified to provide for taxation of gain.
  • Current valuation rules that generally allow substantial discounts for transfer tax purposes for an interest in a closely held business entity, such as an interest in a family limited partnership, would be modified to disallow any such discount for transfers of non-business assets.

Notable Absence of Certain Provisions

As mentioned above, what was just as notable is that many feared changes to longtime rules were not included in the proposal:

  • No increases to the current estate and gift tax marginal rates
  • No changes to the current step up basis regime at death
  • No limitations on like-kind exchanges
  • No required realization of gain on gifts or at death
  • No required realization of gain on assets held in trust, partnership or non-corporate entity after being held in trust for 90 years
  • The top capital gains rate for high-income taxpayers going up to “only” 25% instead of the expected 39.6%

Of course, things are quite fluid and much will change before the ultimate passage of the final tax bill. We’re following developments closely and will post and send updates as things approach passage.

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.

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