Strategies if the Step-Up in Basis is Eliminated

Strategies if the Step-Up in Basis is Eliminated

Posted On March 31, 2021 By Scott Stratton, CFP(R), CFA In Tax Strategies /  1

Today, we look at strategies if the step-up is basis in eliminated for estate planning. There were two new proposals in the Senate this week which will target inherited wealth. These two Acts, if passed, would completely change Estate Planning for many families. The two Acts are called the STEP Act and the 99.5% Act.

The STEP Act

The STEP Act (Sensible Taxation and Equity Promotion Act), proposed by Senators Booker, Sanders, Warren, Whitehouse, and Van Hook would eliminate the Step-Up in Cost Basis. A Step-Up in Basis means that upon Death, an asset has its cost basis reset to the date of death. This allows the heirs to immediately sell an asset and receive the funds without owing any taxes. Or, if they choose to hold on to the asset, they will only owe tax on the capital gains from the date of death forward. Otherwise, they would owe taxes based on their parent’s cost basis (or other decedent).

The STEP Act proposes to eliminate the Step Up in Basis, retroactively to January 1, 2021. In its place, the Act would allow a one-time exclusion of up to $1 million of inherited capital gains. It also allows the tax to be paid over 15 years if it is an illiquid asset like a farm or business. Many older parents have held on to assets, such as mutual funds or real estate, specifically to get a step-up in basis for their children. Allowing for the exclusion of $1 million in capital gains at death will help most families. But include real estate, and many families will have over $1 million in unrealized capital gains. And those families will now be paying a capital gains tax.

The 99.5% Act

The 99.5% Act, proposed by Senator Sanders, will increase the Estate Tax paid by many families. Currently, the Estate Tax Exemption is $11.7 million ($23.4 million for a couple), which has effectively eliminated the Estate Tax for Middle Class Families. Previously, the Estate Tax Exemption was $1 million, as recently as 2003. My clients have welcomed the increase of the Estate Tax Exclusion over the past 17 years. The 99.5% Act includes provisions to:

  • Reduce the Estate Exemption from $11.7 million to $3.5 million.
  • Reduce the Unified Gift Exemption from $11.7 million to $1 million per lifetime.
  • Raise the Estate Tax Rate to a range of 45-65%.
  • Reduce the Annual Gift Tax Exclusion from $15,000 to $10,000 per donee, AND impose an annual limit of $20,000 per donor.
  • Reduce certain tax benefits of Trusts, Generation Skipping Trusts, etc.

While I don’t cater to the ultra-wealthy, I do have a number of Middle Class families who this will impact. Ideas in Washington often stick around until they become reality. So, if these Acts don’t get passed now, don’t think that we will never hear them again. I don’t think there will be much empathy for families who have over $1 million in unrealized capital gains. However, in some cases, children will need to sell the houses, farms, and businesses they inherit to pay for these new taxes.

How Many Taxes?

Just to be clear, the Estate Tax is in addition to any Income Tax or Capital Gains Tax. Under the two proposals, an individual who dies with $5 million, would owe a 45% Estate tax on $1.5 million (the amount above $3.5 million). That’s a $675,000 Estate Tax Bill. Then, if their cost basis was $1 million and the unrealized capital gain was $4 million, the heirs would owe another 23.8% on $3 million of capital gains. That would be another $714,000 in taxes, for a total of $1,389,000. Presently, that tax would be zero, so we are talking about a huge increase. Let’s consider eight strategies if the step-up in basis is eliminated and other changes enacted.

Ways to Reduce Taxes under STEP and 99.5% Acts

1. If the Step-Up in Basis is eliminated, you may want to pay your capital gains gradually. Aim to keep your total unrealized gains under $1 million. For example, if you have $2 million in gains, perhaps you could harvest $100,000 of gains for the next 10 years. The goal is for you to pay the gains gradually at the 15% rate and save your heirs from being taxed at the 23.8% rate.

There is a separate proposal from Biden to increase the long-term capital gains rate for taxpayers in the highest tax bracket to 39.6%. Plus you would be subject to the 3.8% Medicare Surtax and state income taxes. And then, capital gains will be taxed at 43.4% to well over 50% in many states. The government would take more than half of your gains! If that happens, it will be vitally important to harvest gains regularly to avoid pushing your heirs into the top bracket.

Roth IRAs

2. Keep your high growth investments in a Roth IRA. Beneficiaries inherit a Roth IRA income tax-free. The Roth 401(k) looks better every year, versus a tax-deferred Traditional 401(k). If higher taxes are ahead, it may be preferable to use the Roth 401(k).

3. Gradually convert your Traditional IRAs to a Roth. By pre-paying the taxes today, you can both shrink the size of your taxable estate and reduce the Income tax burden on your heirs. The current tax rates will expire after 2025. The next five years is a good window to make Roth conversions.

Plan Your Giving

4. Give away your full Annual Gift Tax Exclusion every year. Reduce your Estate. Please note that the direct payment of someone’s medical or education bills does not count towards the annual exclusion. Do not reimburse your children for those expenses – make the payment directly to the doctor, college, etc.

5. If you make charitable donations, give away your most highly appreciated securities, rather than cash. This will reduce your taxable gains. If you do want to leave money to charity, make a charity a beneficiary of your Traditional IRA. If you are over age 70 1/2, you can make charitable donations of up to $100,000 a year from your IRA as Qualified Charitable Donations, or QCDs. QCDs can reduce your taxes so you have more budget to harvest capital gains from taxable accounts. You do not have to itemize to deduct QCDs.

Other Estate Tax Savings

6. Sell your primary residence. A couple, while alive, can exclude $500,000 in capital gains on the sale of their primary residence, as long as they lived there at least 2 of the past 5 years. ($250,000 for single filers.) Let your kids inherit the house and that capital gains exclusion may be lost. Better to sell it yourself and buy another house where you don’t have the big capital gains.

7. Maximize your contributions to 529 College Savings Plans for your children or grandchildren. These will pass outside of your taxable estate and will grow tax-free for the beneficiaries. 529 Plans will not be taxable under any of these proposals, and will become a more important estate planning tool.

8. Life Insurance proceeds are not subject to income tax to the beneficiary. Additionally, If we establish your insurance policy with an Irrevocable Life Insurance Trust (ILIT) as the owner, the life insurance will pass outside of your Estate and not be subject to the Estate Tax. This didn’t matter as much when the Estate Exemption was $11.7 million. ILITs will benefit a lot more families if the Estate Exemption is reduced to $3.5 million. Include the tax benefits, and Permanent Life Insurance looks even better as an asset.

Higher Taxes Ahead?

I am proud to be an American and pay my fair share of taxes. Still, these proposals represent a massive tax increase on a lot of families. Many professional couples have the potential to have over $3.5 million before they pass away, and easily over $1 million in capital gains, too. We will keep you posted on this legislation. It seems likely that the two Acts will be merged and some compromise reached before a final version is up for a vote.

Luckily, there is a lot we can do to offset some of these proposed taxes and reduce the burden on your Estate and Heirs. Last minute strategies won’t work here, though. Families need to be thinking about their transfer of wealth years and decades ahead of time. Have questions on strategies if the step-up in basis is eliminated? Feel free to drop me an email.

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Inflation and Real Estate

Inflation and Real Estate

Posted On March 26, 2021 By Scott Stratton, CFP(R), CFA In Financial Planning /  

In recent weeks, people have become more concerned about the possibility of inflation and its impact on Real Estate. This is a complex subject, but certainly important for your financial security. With interest rates near historic lows, now is a great time to get a 15 or 30 year mortgage. And with the possibility of inflation increasing, buying a home now could lock in both today’s real estate prices and interest rates.

Globally, governments are spending at an unprecedented rate, taking on vast amounts of debt. According to the US Debt Clock, we presently owe over $224,000 per US taxpayer. Will we ever repay this debt? There’s no appetite for austerity – reducing spending – or raising taxes to payoff the debt. No, we will need to inflate our way out of debt. With 3% inflation, $1,000 in debt will “feel like” only $912 in three years. Ask someone who borrowed $250,000 twenty years ago for a house. It probably felt like a huge amount at the time, but became easier to pay over the years.

For people who don’t have a house, there is a real fear of missing out. Many are concerned that if they don’t buy right now, real estate prices may soon rise to the point where they can no longer afford a house. In densely populated parts of the country, many people are already priced out of the market. People from California, New York, Seattle, etc. are moving to Dallas, Austin, Nashville, or other places in search of better real estate prices and lower taxes.

I bought a house in January and moved to Little Rock, which is even more affordable than Dallas. We are really enjoying our new neighborhood and city. When you work from home, it’s important to have a place you love. So, I understand the feelings people are having about inflation and real estate today. Here’s my advice to first time homebuyers and to people consider their house as an investment.

Buy Versus Rent

I do think now is a great time to buy a house – at least in theory! Owning can make financial sense versus renting, but primarily with two considerations:

  1. The longer you stay in the house, the better. It takes a long time to really benefit from the impact of inflation on real estate. If you stay in the house less than five years, you may only break even, after you pay realtor fees and closing costs.
  2. Your house is still an expense. There are taxes, insurance, mortgage interest, maintenance, furnishings, etc. When I see people stretch for the most expensive house they can afford, it often means they are unable to save as much in their other accounts. Twenty years later, they have only a small 401(k). Meanwhile, their colleagues who maxed out their 401(k)s could have a million dollar nest egg.

So, if you are ready to put down roots, yes, buy a house now. However, I have a feeling that we may see these low interest rates for a while longer. If the time isn’t right for you personally, then wait. If your career may take you to another location, then wait. Growing family? Get a house you can keep and not out grow. I do think you will have plenty of chances to get in real estate in the future. Renting is not only fine, it may even allow you to grow your net worth when you invest your savings versus owning. Renting provides flexibility and fixed costs, versus the surprise expenses that come with having a home. If anything, we need to remove the stigma from renting that it is somehow a barrier to financial success.

Your House is Not an Investment

If Real Estate is such a good inflation hedge, then it would make sense for everyone to buy a million dollar mansion and get rich off their home, right? Should you buy the most expensive house you can afford? Let’s consider this carefully.

Increasing house prices is not the same as an investment return. To measure inflation of real estate, many people refer to the Case-Shiller Home Price Index. It is great data, but flawed if you are trying to use it for an investment rationale. It simply measures the selling price of a house compared to that house’s previous sale. That’s what your return would be as a homeowner, right? No, the homeowner makes much, much less.

While the Index shows what it costs to buy a house, it does not reflect the return to owners. The index does not include: transaction costs (6% realtor commissions are egregious today, really), ongoing expenses (property taxes, insurance, etc.), or improvements. Taxes and Insurance can run 2.5% to 3% a year. Someone who puts in $100,000 in renovations to a house and adds two rooms? Case-Shiller doesn’t consider any of these costs that may occur between sales of a house.

As of 12/31/2020, the Case-Shiller 20-City Composite shows a 10-year price increase of 5.39%. That’s impressive, but that’s not the net return to home owners. So, let’s not think this data is saying that a house is the same as a mutual fund that returned 5.39% over the past 10 years. (By the way, over that same 10 year period, an investment in the Vanguard 500 ETF (VOO) had a return of 13.84%.) Past performance is no guarantee of future results, but I just want people to understand that comparing the Case-Shiller index to an investment return is flawed and not the purpose of that data.

Remodels and Affordability

Planning to remodel? That’s fine to enjoy your home, improve its usability, and to save you from having to move. However, is it a good investment? According to Remodeling Magazine’s 2020 National Data, no type of remodeling recouped 100% of its cost. The top 10 types of remodels recouped 66.8% to 95.6% as a National Average. It’s fine to improve and update your home, but let’s not try to rationalize that decision by thinking that we are making a great investment. The data suggests this is unlikely.

Home affordability: House prices are based on supply and demand. Demand depends on affordability. With years of slow home building, the supply of houses is tight – at least in states with population growth. In areas of population decline, there may be an oversupply. When there are more buyers than sellers, prices rise. In the long run, however, house prices reflect what people can afford.

We’ve had thirty years of falling interest rates. I think my parents’ first mortgage was at 16%. Today, that would be under 3%. That’s one reason why home prices have grown so much. Affordability isn’t based on the home selling price, it’s based on the monthly payment. And since mortgage eligibility is based on your debt to income ratio, home prices cannot increase faster than income in the long run, without falling interest rates. So, I don’t think we are going to see house prices going up by 10% every year if wages only increase by 2%. Who will be the buyers?

Taxes and Investing

It used to be that home ownership came with a nice tax break. That’s no longer the case. I know it seems unfair, but economists finally got through to Washington that the tax benefits were disproportionally helping the ultra wealthy and not the average home owner. For 2021, the standard deduction for a married couple is $25,100. Very few people will itemize. Your itemized deductions include mortgage interest, state and local taxes (with a cap of $10,000), and charitable donations. You probably will not have more than $25,100 in these deductions. That means that you are getting zero tax benefit for your home’s taxes and interest, compared to being a renter. In 2017, I wrote about this change: Home Tax Deductions: Overrated and Getting Worse.

Don’t think of your home as an investment, but as a cost. It’s probably your largest cost. Treat it as a expense to be managed. Your ability to save in a 401(k), IRA, HSA, 529 Plan, Brokerage Account, etc., depends on your preserving the cash flow to fund those accounts. Buy the most expensive house you can and you will be house rich and cash poor. I don’t think that there will be enough inflation in real estate to make that a winning bet.

Your home equity is part of your net worth, but at best consider it like a bond. In spite of today’s inflation concerns and fear of missing out, your home is not likely to make you rich. I remain a fan of the 15-year mortgage and find that my wealthiest clients usually want to be debt-free rather than use leverage to get the biggest house possible. Read: The 15-Year Mortgage, Myth and Reality. Even as home prices increase, please recognize that inflation in real estate is higher than your return on investment once you include all the costs of ownership.

Thinking Long Term

If you are ready to buy a home, now may be a good time. Low interest rates and rising home prices are going to help you. Buying can build your net worth versus renting, if you are ready to stay in one place. Think of your house as an expense and not an investment, and you will enjoy it more and have realistic expectations. Real estate and inflation are linked, but hopefully you now realize that home prices do not equate to return on investment. Build your wealth elsewhere – through investing, creating a business, and growing your career and earnings.

Don’t be afraid of missing out, supply will catch up to demand eventually. And the rise of remote working in the past year means that more people can work from anywhere. People can move to the location they want and can afford. This will help equalize prices nationally, as more workers move from high-cost areas to places with better value.

Low interest rates should cause inflation to pick up. This is government planned financial repression, and it will penalize savers, like grandparents who want to just park their money in CDs. Those will be Certificates of Depreciation – guaranteed to not maintain their purchasing power and keep up with inflation. Low interest rates will benefit debtors, especially when that debt is used to buy appreciating assets and not depreciating things, like cars. Use leverage wisely and it can help grow your net worth. Financial planning is more than just investments, and my goal is to help you succeed in defining and creating your own version of The Good Life.

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10 Year Expected Returns

10 Year Expected Returns

Posted On March 3, 2021 By Scott Stratton, CFP(R), CFA In Portfolio Management /  

With the market rising so fast in the past year, investors are wondering if the 10 year expected returns are still attractive. Are we in a speculative bubble? Other investors see certain stocks soaring and are driving prices even higher. Will recent returns continue? While it’s natural to fret about the future of the stock market, we suggest investors resist the temptation to try to time the market.

It may be helpful, however, to evaluate current valuations and consider how to weight a diversified, buy and hold portfolio. Based on present levels and projected growth, the Vanguard Capital Markets Model calculates the 10 year expected returns for various asset classes. We use this information both in our portfolio construction as well as in our financial planning calculations.

Expected returns today are lower than historical returns. The stock market has risen much faster than corporate earnings. Now, companies need to catch up with their stock valuations. Dividend Yields are lower than historical, as well as economic growth and inflation. All of these are components of projected future Equity returns.

Vanguard recently updated their 10 year expected returns, based on market levels on December 31, 2020. You can compare these figures to six months ago, when I last wrote about Vanguard’s estimates.

Vanguard’s 10 Year Expected Returns

  • US Stocks: 3.0% to 5.0%
  • International Stocks: 6.1% to 8.1%
  • US Growth: -0.1% to 1.9%
  • Value: 4.4% to 6.4%
  • Large Cap: 2.9% to 4.9%
  • Small Cap: 3.2% to 5.2%
  • US REITs: 3.0% to 5.0%
  • US Aggregate Bonds: 0.8% to 1.8%
  • International Bonds: 0.6% to 1.6%
  • Emerging Markets Bonds: 1.5% to 2.5%

These estimates are 10 year annualized projections and are not guaranteed. There will undoubtedly be down years and this is not meant to suggest returns over the next year or in the short-term. Investing involves risk of loss of capital. Source: Vanguard Market Perspectives, March 2021.

Key Takeaways

  1. 10 year expected returns are lower than historical returns. I have cautioned in the past about using historical returns in financial planning projections. We use projected returns. Based on the midpoint of Vanguard’s figures, a 60/40 portfolio with 30% US Stocks, 30% International Stocks, and 40% US Aggregate Bonds has a projected return of 3.85% a year. This may cause some investors to rethink their allocations.
  2. US Growth Stocks are overvalued. US Value is more attractive for a long-term investor today. Be careful of chasing 2020’s hot stocks! We have already built a sizeable position in Value stocks in our models.
  3. International Stocks are more attractive than US Stocks. Be diversified and don’t invest in just US companies. Presently, International Stocks make up 43% of the World Index. If you don’t have at least 43% of your equities in International, you have a Home Bias. This may have worked well in the past decade, but appears less likely to be the case for the next 10 years.
  4. US Small Cap may offer a diversification benefit to Large Cap. REITs on the other hand, have the same return profile as US Stocks, but are riskier (higher volatility). So, we are avoiding REITs in our models.
  5. Bonds and Cash serve primarily as portfolio defense today. They offer little return potential. Vanguard projects inflation will be 1.1% to 2.1% over the next 10 years. Bond and cash returns may be less than inflation, which means you are losing purchasing power. Still, fixed income offers some benefits to rebalance when things are volatile. On their own, bonds are not making much of a positive contribution to portfolio returns.
  6. Preferred Stocks, Convertible Bonds, and Emerging Markets Bonds offer an attractive return potential compared to expected returns on core categories like US Stocks or US Aggregate Bonds. We have expanded our Alternative holdings in 2020 and again in 2021. Read more: Investment Themes for 2021.

Stay Diversified, Don’t Speculate

While we do tilt portfolios towards areas of relative value, it is important to remain diversified. Don’t put all your eggs in the one basket with the highest expected return. There’s no guarantee that Vanguard’s projected returns will become reality. Regardless of short-term market movements, our investment strength comes from keeping costs low, using Index strategies, staying diversified, and tax-efficiency.

The stock volatility over the past 12 months has been remarkable. But, it’s not unprecedented, though. I remember the Tech Bubble in 1999 and the rebound 12 years ago, from March of 2009. Both of those created rampant speculation, which we see today in certain growth stocks, cryptocurrency, and in the options market. Have we not learned the painful lessons of previous day-traders and those who gambled on stocks? Recently, individual investors have been asking me about trading options, Penny Stocks, and day trading stocks with the money they have set aside for a house down payment in one year.

Even as Vanguard is lowering its 10 year expected returns, people are getting greedy, with the fear of missing out on their chance to get rich. They know someone who got lucky over the past year and made a great trade. The lesson from the past is that everyone is a genius in a Bull Market. You could do no wrong in the past year, as long as you did something. Things won’t always be that easy, and that’s why you need a plan. Please make your investment choices about the next 10 years, and not the next 10 hours or 10 days.

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Invest $5,466 a month

Where to Invest $5,466 a Month

Posted On February 5, 2021 By Scott Stratton, CFP(R), CFA In Financial Planning /  

Why should you invest $5,466 a month? Why that very odd number? Well, at an 8% hypothetical return, investing $5,466 a month will get you to $1 million in 10 years. That’s what we are going to explore today and it is very possible for many professional couples to save this much.

Last week, we looked at where to invest $1,000 a month. That’s a reasonable goal for many people, a 10% savings rate for a couple making $120,000 or 15% for an individual making $80,000. And while saving $1,000 a month may be okay, it will take decades to amass enough for retirement. If you want to accelerate the process or aim for a higher goal, you have to save more.

Saving $5,466 a month is $65,592 a year. For a couple making $200,000, that represents saving 33% of your income. That’s challenging, but not impossible. After all, there are many families who get by with making less than $134,000.

There are many different ways you could invest $5,466 a month, but I’m going to focus on adding tax benefits both in the present and future. Let’s get right to it!

Retirement Accounts

  1. Maximize 401(k), $1,625 a month each. That will get you to the 401(k) annual contribution limit of $19,500. It is surprising to me how many people don’t do this. For a couple, that is $3,250, more than half our goal to invest $5,466 a month.
  2. Company match, $416 a month each. Many companies match 5% of your salary to your 401(k). For an employee making $100,000 a year, that equals $416 a month. I am assuming this couple each makes $100,000. For two, that’s $832 a month. Added to your 401(k) contributions and we are now at $4,082 a month.
  3. Backdoor Roth, $500 a month each. At $200,000 for a couple, you make too much to contribute to a Roth IRA. However, you may still be able to make Backdoor Contributions to a Roth IRA, for $6,000 a year or $500 a month each. Added to 1 and 2 above and your monthly total is $5,082. We only need to find another $384 to invest a month to reach the goal of $5,466.

Additional Places to Invest

  1. Health Savings Account (HSA), $600 a month. If you’re a participant in an eligible family plan, you can contribute $7,200 a year to an HSA. That could be up to $600 a month, and that is a pre-tax contribution!
  2. 529 Plan, $1,250 a month. If you are saving for a child’s future college expenses, you could contribute to a 529 College Savings Plan. A 529 Plan grows tax-free for qualified higher education expenses. Most parents choose to stay under the gift-tax exclusion of $15,000 a year per child, which is $1,250/month.
  3. Taxable Account, $ unlimited. You can also contribute to a taxable account. And while you will have to pay taxes on capital gains, dividends, and interest, we can make these accounts relatively tax efficient.

Other Notes

  1. Tax Savings. While trying to invest $5,466 a month is a lot, you will be helped by the tax savings. A couple making $200,000 a year (gross) will have just entered the 24% Federal tax bracket after the Standard Deduction of $25,100 (2021). Some of your tax deductible contributions will be at 24%, but most will be at 22%. Using just 22%, your joint $39,000 in 401(k) contributions will save you $8,580 in taxes. That is $715 a month back in your pocket. Add in $7,200 to an HSA and save another $1,584 in taxes ($132 a month).
  2. Catch-up Contributions. If you are over age 50, you can contribute more to your 401(k) and Roth IRA accounts. There are also catch-up contributions for an HSA if age 55 or older.

I wish more people had the goal of becoming a Millionaire in 10 Years. We cannot control the market, but we can do our part and do the savings. At an 8% hypothetical return, starting to invest $5,466 a month can put you on track to $1 million in a decade. And if you already have $1 million, saving $5,466 for another 10 years would get you to $3.2 million.

For couples making over $200,000, can you afford to invest $5,466 a month? Can you afford not to? Planning is the process of establishing goals and then creating the roadmap to get you there. If you’re ready to create your own roadmap, give me a call.

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Invest $1000 a month

Where to Invest $1,000 a Month

Posted On February 1, 2021 By Scott Stratton, CFP(R), CFA In Financial Planning /  

Many investors wonder where they should invest $1,000 a month. Maybe they’re starting out from scratch. Or maybe they have been doing a 401(k) for years and have additional cash they want to invest.

You’ve paid off your credit cards and have an emergency fund with three to six months of expenses. You’ve got a good paycheck, but it all seems to disappear. Unfortunately, many Americans remain on this paycheck to paycheck treadmill, even if they have a decent income. What breaks this cycle is establishing monthly automatic contributions. Make investing automatic and you will adjust your other spending. And then when you do get a raise, aim to increase your saving, not your spending.

Let’s consider a few ways to invest $1,000 a month. I’ll go into some detail in this first scenario and then give a few variations.

Married with Children

With many couples, one has a good retirement plan at work, but the other spouse does not. For example, maybe they’re self-employed, work part-time, or are a stay at home parent. They’ve got two kids and want to make sure their kids can go to college some day, too.

  1. $500 a month into a Roth IRA. The annual contribution limit is $6,000, which is $500 a month. At an 8% hypothetical return, you would have $745,179 in this Roth IRA after 30 years. And that would be available tax-free! If you had this same amount in a 401(k) and had to pay 22% income tax, you’d be facing a $163,939 tax bill. That’s the amazing tax savings of a Roth IRA.
  2. $450 into 529 College Savings Plans. Put in $225 a month for each kid for college. Like a Roth IRA, a 529 Plan offers tax-free growth, provided the money is used on qualified higher education expenses. At an 8% hypothetical return, you would accumulate $41,162 for your 8-year old to go to college in 10 years. And you’d have $77,858 in 15 years for your 3-year old. (What if one kid doesn’t go to college? Switch the beneficiary to the other child. 529 Details here.)
  3. $50 a month into a 20-year term life insurance policy. For most young families, some life insurance is important and I believe term life is a great solution. For a 38-year old male, we can get a $1 million Term policy for as low as $42 a month if they are in excellent health. Contact me for details.

With their $1,000 a month, this family is on their way to potentially having:

  • $745,000 in tax-free money for retirement in 30 years
  • $119,000 towards their kids’ college
  • A $1 million life insurance policy if something should happen to Dad

Double Income No Kids

  1. $500 a month to two Roth IRAs. Don’t need a 529 Plan or life insurance? You can both do Roth IRAs at $500 a month each. Roth eligibility rules are based on joint income, so if one spouse can contribute, both can. After 30 years at our hypothetical 8%, you’d have almost $1.5 million in two Roth IRAs. That’s the incredible power of compound interest! (Make too much for a Roth IRA? Consider the Backdoor Roth Contribution.)

Self-Employed

  1. $500 a month into a Traditional IRA. Get a tax-deduction for this contribution. However, if you or your spouse are eligible for a retirement plan at work, income limits apply.
  2. $500 into a SEP-IRA. This is also tax-deductible for self-employed individuals. You can do both a SEP and a Traditional or Roth IRA. Since the SEP has much higher contribution limits than a Traditional IRA, why not just put the $1,000 a month into the SEP? The SEP may reduce your QBI Deduction for the Self-Employed.

Invest $1,000 a Month

There are lots of smart ways to invest $1,000 a month. We can help you sort through your options and get started. The Roth IRA offers tax-free growth, whereas the Traditional IRA or SEP-IRA offers an upfront tax deduction. For many parents, you may want to invest some of your $1,000 a month in a 529 College Savings Plan. Term Life Insurance could be a piece of the pie, too.

Another option would be to contribute to a Health Savings Account, or HSA. For 2021, you can contribute up to $300 a month ($3,600 a year) into your HSA, if eligible. This is a tax-deductible contribution and can be withdrawn tax-free for qualified medical expenses in the future. If you have family coverage, the HSA contribution limit doubles to $7,200 a year ($600 a month).

Most people don’t feel like they have an “extra” $1,000 every month. That’s okay. You can start with less, even just $50 a month. Most importantly, just get started. Then, you can gradually increase your monthly contributions over time. Once you get to $1,000 a month, you can go up from there! The more you save and invest, the faster you can reach your financial goals.

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Investment Themes for 2021

Investment Themes for 2021

Posted On January 10, 2021 By Scott Stratton, CFP(R), CFA In Portfolio Management /  

Today we are going to discuss our top Investment Themes for 2021. I’ve stated that predictions are generally worthless, and 2020 certainly proved this point. 12 months ago, no one anticipated the massive impact of the Coronavirus. And the lightning speed of the stock market recovery remains shocking.

From its highs in February, US Stocks fell 35% to March 23. The recovery saw a 65% rally, with the S&P 500 Index ending the year up 17.6%. It was a mind-boggling year for investors, but I think we can count our blessings. This was the fastest Bear Market and recovery in history. Compared to the previous two Crashes, investors felt compelled to stay the course this year. And this proved wise.

(Here’s what I wrote to investors on March 21: Stock Crash Pattern.)

So, where do we go from here? Will 2021 unwind all the gains of 2020? My philosophy remains that we do not need to predict market movements or time the market to be successful. As a long-term investor, my approach to tactical investing is based on over-rebalancing. Think of rebalancing – trimming categories which rose (and became expensive) and adding to what became cheap. We overweight the assets which are cheaper.

We remain fully invested in our target allocation, but the weighting of funds can change from year to year. In some years, we own assets which lag other categories. That’s okay. That’s part of being a diversified investor. We want to avoid chasing performance.

Trades for 2021

  1. US large cap growth has become very expensive. For 2021, we are shifting some of our large cap growth to a mid cap growth fund. The valuations there are not as elevated.
  2. US small cap appears to have turned. Q4 of 2020 was the best quarter for small cap in 30 years. We added to small cap in our Growth and Aggressive models.
  3. Emerging Markets have a high expected long-term return. We remain overweight in EM.
  4. Value stocks lagged growth names again in 2020. (Growth stocks performance was highly concentrated in a small number of tech stocks such as Facebook, Amazon, Alphabet, and Tesla.) We are committed to our Value Funds and believe that they are compelling today.
  5. Bond yields fell in 2020 to all-time lows. The US Aggregate Bond Index had a return of 7.4%, but most of that was from prices increasing. Less than 2% came from yield. So, we finished 2020 with terrible yields – less than 1% on a 10-year Treasury bond.
  6. Yields were up in the first week of 2021, and bond investors are seeing falling prices. We are positioned towards the short-end of the yield curve and want to avoid chasing high yield today.
  7. Fixed Annuities remain a good substitute for CDs and Bonds for investors who don’t need liquidity. We can get a 5-year annuity at 3.0%.
  8. There are relative values within municipal bonds and Emerging Markets debt. Other than that, we expect very low returns from bonds. Own them for diversification. They provide ballast if your stocks are down and give you the ability to rebalance.
  9. We trimmed some short-term bonds and added to Preferred Stocks. Although many are priced at par today, we can get yields of 4-6%. This is an attractive middle ground between the volatility of stocks and the 0-1% yields of bonds.
  10. Both stocks and bonds are at all-time highs right now, and that makes alternatives compelling. In addition to Preferred Stocks, we have positions in Convertible Bonds and a Hedge Fund Strategy mutual fund.

Adding Value

We certainly hope markets will rise in 2021, but there’s no guarantee that will happen. I can say that we added value in 2020 in three other ways:

  • In March, we harvested losses in taxable accounts. For example, we sold one large cap ETF and immediately replaced it with a different large cap ETF. Losses will offset capital gains distributions and will carry forward indefinitely.
  • We rebalanced in March, trimming bonds and buying stock ETFs which were down. These trades proved profitable, although they didn’t feel so good when the market was crashing.
  • We stayed the course throughout the year. Selling during a panic like March would have been disastrous. We believe that planning and behavior are fundamental to success.

Our investment themes for 2021 are not predictions. We can’t control what the market will do. Our focus is to think long-term, stay diversified, and keep costs and taxes down. Still, our portfolio models are not static. We make changes to the weightings of our Core positions based on their relative valuations. And we add or remove Satellite positions that are attractive for the current environment.

Investments are a tool to grow your wealth and achieve your financial and life goals. While I enjoy discussing investments, more of my conversations with clients are around their objectives and making sure they are on track. And that’s how it should be.

Behind the scenes, a lot of research, thought, and analysis goes into our investment management decisions. If you’d like to ask about your portfolio and how we invest, please give me a call.

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COVID Relief Bill

COVID Relief Bill Passes

Posted On December 23, 2020 By Scott Stratton, CFP(R), CFA In Financial Planning /  

A new bi-partisan COVID Relief bill passed Congress this week and will impact almost every American in a positive way. This stimulus legislation creates additional income and tax benefits to offset the economic damage of Coronavirus. The $900 Billion bill includes another stimulus payment to most Americans, an extension of unemployment benefits, and seven tax breaks. As of this morning, President Trump has not yet signed the bill.

$600 Stimulus Payment

The CARES Act provided many families with stimulus checks this summer. Those checks were for up to $1,200 per person and $500 per child. There will be a second stimulus check now, for $600 per person. Parents will receive an additional $600 for each dependent child they have under 17. Adult dependents are not eligible for a check.

Like the first round of checks, eligibility is based on your income. Single tax payers making under $75,000 are eligible for the full amount. Married tax payers need to make under $150,000. There is a phaseout for income above these thresholds.

Payments will be distributed via direct deposit, if your bank information is on file with the IRS. If not, like before, you will be mailed a pre-paid debit card. This payment will not be counted as taxable income. Payments should start in a week and are expected to be delivered much faster than the two months it took this summer.

These $600 payments are again based on your 2019 income, but will be considered an advanced tax credit on your 2020 income. What if your 2019 income was above $75,000, but your 2020 income was below? If you qualify on your 2020 income, the IRS will provide the $600 credit on your tax return in April. If they send you the $600 based on your 2019 income and your 2020 income is higher, you do not have to repay the tax credit. This is a slightly different process than the first round of checks, and will benefit people whose income fell in 2020.

Unemployment Benefits

The CARES Act provided $600 a week in Federal Unemployment Benefits, on top of State Unemployment Benefits. This amount was set to run out on December 26. The new COVID Relief Bill provides an 11-week extension with a $300/week Federal payment. Now, unemployed workers will have access to up to 50 weeks of benefits, through March 14. Unfortunately, because of how late the legislation was passed, states may be unable to process the new money in time. So, there may be a gap of a few weeks before benefits resume.

Seven Other Tax Benefits

  1. Child Tax Credit and Earned Income Tax Credit. Under the new legislation, tax payers can choose between using their 2019 or 2020 income to select whichever provides the larger tax credit.
  2. Payroll Tax Deferral. For companies who offered a deferral in payroll taxes in Q4, the repayment of those amounts was extended from April to December 31, 2021.
  3. Charitable Donations. The CARES Act allows for a $300 above-the-line deduction for a 2020 cash charitable contribution. (Typically, you have to itemize to claim charitable deductions.) The new act extends this to 2021 and doubles the amount to $600 for married couples.
  4. Flexible Spending Accounts (FSAs). Usually, any unused amount in an FSA would expire at the end of the year. The stimulus package will allow you to rollover your unused 2020 FSA into 2021 and your 2021 FSA into 2022.
  5. Medical Expense Deduction. In the past, medical expenses had to exceed 10% of adjusted gross income to be deductible. Going forward, the threshold will be 7.5% of AGI. This will help people with very large medical bills.
  6. Student Loans. Under the CARES Act, an employer could repay up to $5,250 of your student loans and this would not be counted as taxable income for 2020. This benefit will be extended through 2025.
  7. Lifetime Learning Credit (LLC). The LLC was increased and the deduction for qualified tuition and related expenses was cancelled. This will simplify taxes for most people, rather than having to choose one.

Read more: Tax Strategies Under Biden

Summary

The new COVID Relief Bill will benefit almost everyone and will certainly help the economy continue its recovery. For many Americans, the stimulus payments and continued unemployment benefits will be a vital lifeline. Certainly 2020 has taught all of us the importance of the financial planning. Having an emergency fund, living below your means, and sticking with your investment strategy have all been incredibly helpful in 2020.

Read more: 10 Questions to Ask a Financial Advisor

If you are thinking there’s room for improvement in your finances for 2021, it might be time for us to meet. Regardless of what the government or the economy does in 2021, your choices will be the most important factor in determining your long-term success. We will inevitably have ups and downs. The question is: When we fall, are we an egg, an apple, or a rubber ball? Do we break, bruise, or bounce back? Planning creates resilience.

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retirement buckets

Retirement Buckets

Posted On December 11, 2020 By Scott Stratton, CFP(R), CFA In Retirement Planning /  

Our fifth and final installment of our series on retirement income will cover the strategy of five-year retirement buckets. It is a very simple approach: you maintain two buckets within your portfolio. Bucket 1 consists of cash and bonds sufficient for five years of income needs. Bucket 2 is a long-term growth portfolio (stocks).

We could start with up to a 5% withdrawal rate. Let’s consider an example. On a $1 million portfolio, we would place $250,000 in Bucket 1. That is enough to cover $50,000 in withdrawals for five years. Bucket 1 would be kept in cash and bonds, for safety and income. Each year, you would take withdrawals from Bucket 1.

Bucket 2, with $750,000, is your stock portfolio. The goal is to let this money grow so that it can refill Bucket 1 over time. In years when Bucket 2 is up, we can refill Bucket 1 and bring it back up to five years worth of money. At $750,000, a 6 2/3% annual return would provide the $50,000 a year needed to refill Bucket 1.

Addressing Market Volatility

When the market is flat or down, we do not take a withdrawal from Bucket 2. This addresses the big risk of retirement income, having to sell your stocks when they are down. Instead, by having five years of cash in Bucket 1, we can wait until the market recovers before having to sell stocks. That way, you are not selling stocks during a time like March of 2020, or March of 2009! Instead, we hold on and wait for better times to sell.

Historically, most Bear Markets are just for a year or two, and then the market begins to recover. Sometimes, like this year, the recovery is quite fast. The goal with our Retirement Buckets is to never have to sell during a down year. And while it is always possible that the stock market could be down five years in a row, that has never happened historically.

Retirement Buckets is different from our other withdrawal strategies, such as the 4% rule or the Guardrails strategy. Those strategies tend to have a fixed asset allocation and rebalance annually. The Retirement Buckets Strategy starts with a 75/25 allocation, but that allocation will change over time. Our goal is not to maintain exactly 25% in the cash/bonds bucket, but rather to target the fixed amount of $250,000. If the market is down for two years, we may spend Bucket 1 down to $150,000.

Stocks for Growth

For most people, having five years of cash and bonds in reserve should be sufficiently comfortable. However, if you wanted to increase this to 7 years, a 65/35 initial allocation, that would also work. But, I would suggest starting with at least a 60% allocation to stocks. That’s because when Bucket 2 is smaller, you need an even higher return to refill the $50,000 a year. If you started with 60/40 ($600,000 in Bucket 2), for example, you’d need a return of 8 1/3%.

Retirement Buckets can work because you are creating flexibility around when you are going to sell stocks. When you maintain any fixed allocation, you run into the problem of selling stocks when they are down. Rebalancing is good when you are in accumulation – it means you are buying stocks when they are low. But for retirement income strategies, selling stocks when they are down is likely going to be a bad idea.

Selling Bonds First

Somewhat related to a Buckets Strategy is another income strategy, the Rising Equity Glidepath. In this approach, you sell your bonds first. So, if you started with a 60/40 allocation at retirement and withdraw 4% a year, your bonds would last you 10 years (actually a little longer, with interest). If you avoid touching your stocks for 10 years, they are likely to have doubled in value, historically, with just a 7% annual return. I see the Rising Equity Glidepath as being related to the buckets strategy because both approaches focus on not selling stocks. This reduces the Sequence of Returns risk that market losses impact your initial retirement years.

However, most investors become more conservative as they age, so they aren’t going to like the Rising Equity Glidepath. If they retire at 65, that puts them on track to be at 100% equities at age 75. That’s not what most want. So, even though the strategy looks good in theory, it’s not going to make sense in practice.

What’s Your Plan?

The Retirement Buckets approach can provide a strategy that is logical and easily understood by investors. We maintain five years of cash and bonds, and can replenish the cash bucket when the market is up. This gives you a flexible process for how you are going to fund your retirement and respond to market volatility.

I hope you’ve enjoyed our series on retirement income approaches. It is so important to understand how to create sustainable withdrawals from your portfolio. Whether you are already retired or have many years to go, we are here to help you find the right strategy for you.

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guardrails withdrawal strategy

Guardrails Withdrawal Strategy

Posted On December 1, 2020 By Scott Stratton, CFP(R), CFA In Retirement Planning /  

After looking at Bengen’s 4% Withdrawal Rule last week, today we turn to the Guardrails Withdrawal Strategy created by Guyton and Klinger in 2006. Bengen’s 4% Rule is a static withdrawal strategy – he tested various fixed withdrawal rates over 30-year periods to calculate a safe withdrawal rate for retirement income. This is a static approach because he did not attempt to adjust withdrawals based on market performance.

As a result, one criticism of the 4% Rule is that it is too conservative and is based on the historical worst case scenario. In many scenarios, retirees could have taken much more income than 4%. Or they could have retired years earlier! In bad market scenarios, it also seems unlikely that a retiree would continue to increase their withdrawals every year for inflation if it risked depleting their assets.

A Dynamic Withdrawal Strategy is one which adjusts retirement income up or down based on market performance. Guyton’s Guardrail approach establishes a framework for retirees to adjust their income if necessary. The benefit is that you could increase your withdrawals if performance is above average. It also means you may need to reduce withdrawals during a bad stretch. A dynamic approach means you could start with a much higher withdrawal than just 4%. The guardrails creates an ongoing process to know if your withdrawal rate is in the safe zone or needs to change.

Guyton’s Guardrail Rules

Like Bengen’s framwork, Guyton looked at historical market performance over a 30-year retirement. Here are the main points of his Guardrails Withdrawal Strategy:

  • Your initial withdrawal rate could be 5.4%.
  • You increase withdrawals for inflation annually, EXCEPT in years when the portfolio has fallen in value, OR if your withdrawal percentage exceeds the original rate of 5.4%. In those years, you keep the same withdrawal amount as the previous year.
  • If a market drop causes your current withdrawal rate to exceed 6.48%, then you need to cut your withdrawal dollars by 10%.
  • If market gains cause your withdrawal rate to fall below 4.32%, then you can increase your withdrawal dollars by 10%.
  • This strategy worked with allocations of 65/35 and 80/20. With a 50/50 portfolio, the safe withdrawal rate drops from 5.4% to 4.6%.
  • After a year when stocks were down, withdrawals should only come from cash or bonds. On years when the market is up, he would trim stocks and add to cash to meet future withdrawals.

On a $1 million portfolio, the Guardrails approach suggests you could safely withdraw $54,000 in year 1. That’s significantly higher than the $40,000 under Bengen’s static 4% rule. And while you might forgo annual inflation increases if the market does poorly, you were already starting at a much higher income level. Even if you had a 10% cut in income, from $54,000 to $48,600, you are still getting more income than if you were using the 4% Rule.

Dynamic Withdrawal Range

The Guardrails approach establishes an ongoing withdrawal range of 4.32% to 6.48%. That is a 20% buffer from your original 5.4%. If your withdrawal rate goes outside of this range, you should decrease (or can increase) your withdrawals. The static 4% rule only focused on your initial withdrawal rate and then just assumes you make no changes regardless of whether your future withdrawals are high or low. The 4% rule is an interesting study of market history, but I think retirees want to have a more strategic approach to managing market risk.

The benefit to a retiree for implementing a Guardrails approach is significant. If you need $40,000 a year, you would only need an initial nest egg of $740,740 with the guardrails, versus $1 million under the 4% rule. And you now have a clear process each year to evaluate the sustainability of your current withdrawals. You are responding to markets to aim for an effective retirement strategy.

Calculating a sustainable withdrawal rate for retirement income will always be an unknown. We’ve talked about the challenges of sequence of returns risk, inflation, and longevity. While we can’t predict the future, having a dynamic approach to retirement withdrawals is appealing and intuitive. Is a Guardrails Withdrawal Strategy right for you? Along with portfolio management, our retirement planning process can offer great peace of mind that you are taking a prudent, well-thought approach to managing your wealth.

You only get one retirement. If you are retired or will be retiring within three years, you need a retirement income plan. Find out more:

Schedule a Free Call.
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The 4% Withdrawal Rule

The 4% Withdrawal Rule

Posted On November 20, 2020 By Scott Stratton, CFP(R), CFA In Retirement Planning /  

Many retirement income projections are based on the work of William Bengen, a financial advisor who created the 4% withdrawal rule. Today, in part three of our five-part series on creating retirement income, we look at Bengen’s 4% Rule and what it can mean for your retirement.

Bengen’s Research

Twenty-five years ago, there had been little research done on how to create retirement income from a portfolio. Thankfully, most people had pensions which guaranteed their payments. However, with the rise of 401(k) plans, the responsibility for retirement income shifted from the employer to the employee and their investment portfolio. We needed a more rigorous framework for retirement planning.

Bengen looked back at the history of the stock and bond returns and considered a 30-year retirement period. Since inflation increases your cost of living, he assumed that retirees would need to increase their retirement withdrawals annually. He then calculated, for every period, the maximum withdrawal rate that would have lasted for the full 30 years, adjusting for inflation.

He examined this for every 30 year period with available data. For example, 1930-1960, and then 1931-1961, 1932-1962, etc. all the way up to the present. In the all 30-year periods, retirees were able to withdraw at least 4% of their initial sum. In the worst case scenario, retirees with a $1 million portfolio could withdraw $40,000 in year 1, and increase it every year with inflation. This is the Safe Withdrawal Rate, or SAFEMAX as Bengen called it.

Interestingly, Bengen did not name this the 4% Rule. In interviews with reporters, they started calling it the 4% Rule and the name stuck.

Portfolio Implications

Bengen originally used a simple two asset portfolio using one-half US Large Cap Stocks and one-half US Intermediate Treasury Bonds. He assumed annual rebalancing, which helped with stock market volatility. He found that the 4% Rule would work with about one-half to three-quarters invested in stocks. With higher allocations to stocks, the portfolio became more likely to implode during bear markets. And with higher allocations to bonds, the portfolio could not keep up with the inflation-adjusted withdrawals. So, the sweet spot for a retirement allocation seemed to be from 50/50 to 75/25.

In the majority of 30-year periods, the potential withdrawal rate was much higher than 4%. In a few periods, it even exceeded 10%. The 4% rate was the worst case scenario. 4% worked for all of the 51 different 30-year periods starting in 1926 that Bengen considered in his original paper. At a 4% withdrawal rate, your money actually grew in most of the periods. If you started with a $1 million portfolio and took 4% withdrawals, your portfolio would have actually exceeded $1 million, 30 years later, in the majority of cases.

Later, Bengen added Small Cap stocks to the mix, with a portfolio of 30% large cap, 20% small cap, and 50% bonds. With this portfolio mix, he found that the safe withdrawal rate increased to 4.5%. Bengen considers this work to replace his initial 4% Rule. Unfortunately, the name had already caught on and Bengen will forever be known as the creator of “The 4% Rule”, but he would rather it was called “The 4.5% Rule”.

There is definitely room for higher withdrawals than 4%. The problem is that we don’t know what future returns will be and we don’t know the sequence of returns. So, the safest bet remains to start at only a 4% withdrawal. For people who retire before age 65, we may want to plan for a longer potential horizon than Bengen’s 30 year assumption. A longer retirement might require a lower rate than 4%.

Summary

The 4% Withdrawal Rule is a good rule of thumb for retirement income. When we use other analytical tools, such as a Monte Carlo evaluation, it often generates results similar to Bengen’s rule. If you want to use a 4% rate, your nest egg needs to be 25-times your annual needs. This is a very high hurdle for most people. It’s incredibly challenging for most Americans to save 25 times their annual expenses during their working years.

So while it is a conservative way to calculate retirement income, the 4% rule may make people over-prepared in most periods. As a result, people could have spent more money in retirement. Or they could have retired years earlier, but waited to accumulate enough assets to meet the 4% Rule. That’s a flaw with the 4% Rule.

The other weakness is that it is based on history. Just because it worked in the past century is no guarantee that it will work in the future. For example, if we have very low bond yields, poor stock returns, or higher inflation, it’s possible that a 4% withdrawal fails. One researcher, Wade Pfau, tried to apply the 4% Rule to investors in other countries. He found that it didn’t work for every country. We have had a really good stock market, and low inflation, here in the US and that’s why it worked historically.

Bottom line: the 4% Withdrawal Rule is a good starting place to understand retirement income. But we can do better by having a more dynamic process. We can adjust withdrawals based on market performance. Or you can delay or reduce inflation adjustments. We can avoid selling stocks in down years. All of these strategies can enhance the 4% rule and potentially enable you to start with a higher withdrawal rate. We will consider two such strategies in the next articles, considering Guardrails and a 5-year Bucket Approach.

Bengen is retired now, but still writing and continuing his research. He realized that his initial research left a lot of money on the table for retirees. Two months ago, he produced a new article looking at stock market valuations and inflation to refine the initial withdrawal rate. If you are retiring when stocks are expensive, future returns are likely to be lower, and you should start with a lower withdrawal rate. If stocks are cheap, you might be able to start with a higher withdrawals than 4%. Bengen believes this new process could calculate a safe-withdrawal rate of 4.5% to 13%. (The present calculation using his new method is 5.0%.) Time will tell if his new research gains wider acceptance, but for now, he will be best known as the father of the 4% withdrawal rule.

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