SECURE Act 2.0 Retirement Changes

Secure Act 2.0 Retirement Changes

The SECURE Act 2.0 passed this week after being discussed in Washington for nearly two years. The Act could not make it through Congress on its own, but it was stuffed into the Omnibus Spending Bill that was required to avoid an imminent government shutdown. I’ll save that rant for another day and focus on some of the dozens and dozens of changes to retirement planning in the Secure Act 2.0 which will affect you.

First, some background: The original SECURE Act was passed in December 2019. This legislation was the largest change to retirement planning in recent decades. It included increasing the age of RMDs from 70 to 72 and eliminating the Stretch IRA for beneficiaries.

The SECURE Act 2.0 goes even further and has a large number of changes to help improve retirement readiness for Americans. We are not going to cover all of these changes, but focus on a few key areas that are likely to apply to my clients.

Required Minimum Distributions

The SECURE Act 2.0 will gradually increase the age of RMDs from 72 to 75. Next year, the age to start RMDs will be 73, and then this will increase to age 75 in 2033. So, if you were born before 1950, your RMD age will remain 72 and you have already started RMDs. If you were born between 1951-1959, your RMD age is 73. And if you were born in 1960 or later, RMDs will begin in the year you turn 75.

I’m happy to see RMDs pushed out further to allow people to grow their IRAs for longer. For investors, this will extend the window of years when it makes most sense to do Roth Conversions. People are living longer and we should be pushing out the age of RMDs and starting retirement.

Roth Changes

Washington loves Roth IRAs. Anyone who thinks Washington doesn’t like Roths should consider the incredible expansion to Roths in SECURE Act 2.0. Roths are here to stay.

First, SEP IRAs and SIMPLE IRA plans will be amended to include Roth Accounts. This brings them up to par with 401(k) plans which have offered a Roth option for several years now. What does this mean? Roth contributions are after-tax and grow tax-free for retirement. You will be able to now open a Roth SEP or a Roth SIMPLE. Do you have a W-2 job and also self-employment income? You can do a 401(k) at work and also a Roth SEP for your self-employment.

2.0 also eliminates the RMD requirement from Roth 401(k)s. This was an odd requirement, and could easily be avoided by rolling a Roth 401(k) to a Roth IRA. But it still caught some people by surprise, so I am glad they eliminated this.

Starting in 2023, Employers may now make matching contributions into Roth 401(k) sub-accounts for employees. These additional contributions will be added to the employee’s taxable income. So, this may not make sense for everyone.

Forced Roth for Catch-Up Contributions

In 2024, high wage earners will be forced into using a Roth sub-account for catch-up contributions. If you are over age 50, you can make catch-up contributions. If you made over $145,000 in the previous year, your catch-up contributions must go into a Roth 401(k) starting in 2024. You will no longer be able to make Traditional (“deductible”) contributions with catch-up amounts. Oh, and if your company does not currently offer a Roth option, everyone over 50 will be prohibited from making any catch-up contributions.

This one will be a mess and is one of the only negative impacts we will see from SECURE Act 2.0. It will take many months for 401(k) providers and employers to update their systems and figure out how to implement these new changes.

Lots of Roth changes, but what isn’t here? The SECURE Act 2.0 didn’t eliminate the Backdoor Roth IRA. Many in Congress have been wanting to kill the Backdoor Roth, but it lives on. There are no new restrictions on Roth Conversions of any sort. Why so much love for Roths? Washington wants your tax money now, not in 30 years.

529 Plan to Roth

What if you fund a 529 College Savings plan for your child and they don’t use all the money? Currently, you can change the 529 plan to another beneficiary. But if you don’t have another beneficiary, withdrawing the money could result in taxable gains and a 10% penalty. The SECURE Act 2.0 is creating a third option: you can rollover $35,000 from a 529 plan to a Roth IRA for the beneficiary.

Here are the requirements. You must have had the 529 plan open for at least 15 years. You cannot rollover any contributions made in the preceding five years. Each year, the amount rolled from the 529 to the Roth is included towards the annual Roth contribution limit. For example, this year the limit is $6,500. The maximum you could roll from a 529 would be $6,500. But if the beneficiary already contributed $3,000 to an IRA (Roth or Traditional), you could only roll $3,500 from the 529 to the Roth. Thankfully, there are no income limitations to make this rollover. The lifetime limit on rolling over a 529 to a Roth will be $35,000, so this may take 5-6 years assuming the beneficiary makes no other IRA contributions.

You can change the beneficiary of a 529 plan to yourself. So, could you take an old 529, change the beneficiary to yourself and then roll it into your own Roth IRA? It is unclear in the legislation if a change in beneficiary will start a new 15-year waiting period. We will have to wait for additional rules to find out.

Other SECURE Act 2.0 Retirement Changes

So many changes! (Here is the most detailed summary I have seen so far.) These won’t impact everyone but I am studying all of these to see who might benefit:

  • IRA catch-up amounts will be indexed to inflation and increase in $100 increments.
  • 401(k) Catch-up contributions will be increased for ages 60-63. The amount will be $10,000 or 150% of the annual amount, whichever is higher.
  • QCD (Qualified Charitable Distributions) limit of $100,000 will be indexed to inflation.
  • New exceptions to the 10% premature distribution penalty.
  • Emergency Savings Accounts, allowing people to access their 401(k)s without penalty. (Bad idea, but so many people in distress do this and then have to pay penalties and taxes, hurting them even further.)
  • QLAC limit increased to $200,000.
  • Allowing matching 401(k) contributions for payments towards student loans.
  • Tax credits for small employers who start a retirement plan.
  • New Starter 401(k) plans.
  • Lower penalties for missed RMDs.

I appreciate that Washington wants to make it easier for Americans to save for retirement. The SECURE Act 2.0 has a vast amount of retirement changes to incentivize the behavior the government wants to see. For those who are able to save for retirement, they are making it easier to save and accumulate assets. Your retirement is your responsibility! And retirement planning is my job. I’m here to help with your questions, preparation, and implementing your retirement goals.

Stocks Versus Bonds Today

Stocks Versus Bonds Today

Where is the best opportunity – in stocks or bonds? I’ve been enthusiastic about the rising interest rates in 2022 and this has impacted the relative attractiveness of stocks versus bonds today. What do we expect from stocks going forward?

Vanguard’s Investment Strategy Group publishes their projected return for stocks for the next 10 years. And while no one has a crystal ball to know exactly how stocks will perform, this is still valuable information. They look at expected economic growth, dividend yield, and whether stock values (P/E ratios for example) might expand or contract.

Their median 10-year expected return for US stocks is 5.7%, with a plus or minus 1% range, for a range of 4.7% to 6.7%. This is actually up from the beginning of the year. As stocks have fallen by 20%, we are now starting from a less expensive valuation. But a projected return of 5.7% for the next decade would be well below historical averages, and most investors are hoping for better.

Is Vanguard being too pessimistic? No, many other analysts have similar projections which are well below historical returns. For example, Northern Trust forecasts a 6% return on US stocks over the next five years. And of course, these are just projections. Returns could be better. Or worse!

Bonds Are An Alternative

Last week, I bought some investment grade corporate bonds with a yield to maturity of 6% over three to five years. Bonds have much less risk than stocks and have only a fraction of the volatility of stocks. As long as the company stays in business, you should be getting your 6% return and then your principal back at maturity.

If we can buy a good bond with a return of 5.5% to 6.0%, that completely matches the projected stock returns that Vanguard expects. Why bother with stocks, then? Why take the risk that we fall short of 6% in stocks, if we can get a 6% return in bonds? Today, bonds are really attractive, even potentially an alternative to stocks.

For many of our clients, bonds look better than stocks now. And so we may be trimming stocks by year end and buying bonds, under two conditions: 1. The stocks market remains up. We are not going to sell stocks if they fall from here. 2. We can buy investment grade bonds, 3-7 years, with yields of at least 5.5% and preferably 6%. And we have to find different bonds, because we aim to keep any one company to no more than 1-2% of the portfolio.

We won’t be giving up on stocks – not at all. But we may look to shift 10-20% of that US stock exposure to bonds.

Three Paths for the Market

I think there are three scenarios, all of which are okay.

  1. Stocks do way better than 6%. The risk here is that stocks could perform much better than the 5.7% estimate from Vanguard. Maybe they return 8% over the next five years. Well, this is our worst scenario: we make “only” 6% and are kicking ourselves because we could have made a little bit more if we had stayed in stocks.
  2. Stocks return 6% or less. In this case, it is possible we will get the same return from bonds as the expected return from stocks. And if stocks do worse than expected, our bonds might even outperform the stocks. That’s also a win for bonds.
  3. Stocks decline. What if the economy goes into recession, and stocks drop? If stocks are down 10% and we are up 6% a year on bonds, we will be really happy. In a recession, it’s likely that yields will drop and the price of bonds will increase. The 6% bond we bought might have gone up in value from 100 to 104. Then, our total return on the bond might be 10%, and we could be 20% ahead relative to stocks’ 10% drop. And in this scenario, we don’t have to hold the bonds to maturity. We could sell the bonds and buy stocks while they are down.

Smoother is Better

I’m happy with any of those three scenarios. Many investors are feeling some PTSD from the market performance since 2020. Many will be happy to “settle” for 5.5% to 6% from bonds, versus the 5.7% expected return from stocks. And of course, stocks won’t be steady. They may be up 20% one year and down 20% the next. It is often a roller coaster, and so increasing bonds may offer a smoother ride while not changing our expected return by much at all.

Should everyone do this? No, I think if you are a young investor who is contributing every month to a 401(k) or IRA, don’t give up on stocks. Even if the return ends up being the same 6%, you will actually benefit from the volatility of stocks through Dollar Cost Averaging. When stocks are down, you are buying more shares. So, if you are in accumulation, many years from retirement (say 10+), I wouldn’t make any change.

But for investors with a large portfolio, or those in or near retirement, I think they will prefer the steady, more predictable return of bonds. When the yield on bonds is the same as the 5-10 year expected return on stocks, bonds make a lot of sense. The risk/reward comparison of stocks versus bonds today is clear: bonds offer the same expected return for less risk. We will be adding to bonds and adjusting our portfolio models going into 2023.

Inflation Investment Ideas

Inflation Investment Ideas

Inflation continues to shock the Global economy and has become a major concern when we discuss investment ideas. This week’s data showed the Consumer Price Index up 9.1% over last year, and the Producer Price Index is up over 11%. These are numbers not seen since 1981.

Today, I’m going to share some thoughts on inflation and get into how we want to respond to this situation. But first, here is an inside look at the government response to inflation.

Federal Reserve Hitting the Brakes

Last week, I attended a breakfast meeting for the Arkansas CFA Society at the Federal Reserve office in Little Rock. Our guest speaker was James Bullard, president of the St. Louis Federal Reserve Bank and voting member of the Open Market Committee which sets interest rates.

Bullard said that we were at a profound regime switching moment today, and that this is not just a blip in inflation but a “stunning amount of inflation”. He stated that the Fed would move aggressively to reduce inflation and that they were committed to their inflation target of 2%. He thinks the Fed will continue to raise rates until policy rates are greater than the inflation rate and may need to hold those high rates for years to come to bring inflation down.

Bullard felt that the current inflation levels are not simply a temporary supply shock from the Ukraine War. Output is actually up. In March 2020, the Fed responded very quickly to support an economy crashing from COVID-19 shutdowns. 60 days later, markets recovered and housing boomed. He wishes that they had reduced their asset purchases sooner. Instead, the Fed is only now ceasing to buy bonds and is allowing their holdings to run-off as they mature. The global stimulus response was correct, but has overheated.

He was less concerned about the possibility of a recession. Bullard said that recessions are difficult to predict and that the Fed is going to focus on getting inflation under control first. Inflation remains a global problem, but the US Federal Reserve will lead the way on fighting inflation, as the European Central Bank has other issues making them slower to respond.

Inflation, Rising Rates, Recession

It’s important to understand that even if inflation remains elevated for a couple of years, the impact of inflation may only be part of the story. Our investment ideas cannot simply assume high inflation as the only factor. We have to also consider the likelihood of rising interest rates and a recession. We’d love it if the Federal Reserve can orchestrate a soft landing as they apply brakes to this runaway economy. But they have not been very good at soft landings in the past.

The Fed policies are starting to work. Since the June inflation numbers, we’ve already seen the price of oil down by 20%. Mortgage applications are down and we should start to see housing inventories normalize and home prices stop their double digit increases. Interest rates have doubled compared to last year – 5.5% versus 2.75% for a 30-year mortgage – and this will impact how much home buyers can afford to pay. The Bloomberg Commodity Index was at 130 on June 16th and is now at 113, a drop of 13% in one month.

It is hard to imagine additional inflation shocks or surprises at this point. Despite the headlines, markets already know we have inflation. Inflation remains high, but may have peaked and should be starting to come down. The question is what is next? How will the markets respond to the Fed actions? Here are five thoughts about where to go from here.

Five Inflation Investment Ideas

  1. Rising Rates. Bond investors beware. The Fed is going to continue to raise interest rates for an extended period. Keep your duration short on bonds. Consider floating rate bonds, if you don’t have any. Stay high quality – rising rates may cause defaults in weaker credits.
  2. I-Bonds. These are inflation linked US savings bonds. They’ve been in the news this year, but I’ve been writing about them since 2016. Limited to $10,000 in purchases a year. These could do great for a couple of years.
  3. Recession and Stocks. We might already be in a recession today, but won’t know it until later economic data shows a negative GDP for two quarters. Please resist the temptation to try to time the stock market. Recessions are a lagging indicator; stocks are a leading indicator and stocks will bounce back sooner. If you try to get out of stocks, it will be very difficult to get back in successfully. Instead, focus on diversification, with Value and Quality stocks. Avoid the high-flying growth names, we are already seeing those stocks get pummelled.
  4. Roth Conversions. We are in a Bear Market, with the S&P 500 Index down 20%. This could be a good time to look at Roth Conversions, if you believe as I do that stocks will come back at some point in the future. An index fund that used to be $50,000 is now trading for $40,000. Do the Roth Conversion, pay taxes on the $40,000 and then it will grow tax-free from here. This works best if you anticipate being in a similar tax bracket in retirement as today.
  5. Cash is Trash. Inflation is reducing your purchasing power. Thankfully, rising interest rates means we can now earn some money on Bonds and CDs. We can build laddered bond portfolios from 1-5 years with yields of 3-5%. And we have CDs at 3% as short as 13 months. Those are a lot better than earning 0% on cash. If you don’t need 100% liquidity, short-term bonds, CDs, and T-Bills are back.

Perseverance and Planning

I believe in long-term investing. Times like these will challenge investors to have the perseverance to stay the course. Rising rates and a possible recession in the months ahead may pose additional losses to our investment portfolios. If I thought we could successfully avoid the losses and step away from the market, I’d do that in a heartbeat. But all the evidence I have seen on market timing suggest it is unlikely to add any value, and would probably make things worse. We will stay invested, continue to rebalance, tax loss harvest, and carefully consider our options and best course of action.

With higher inflation, the cost of living in retirement increases, and so we have to aim for equity-like returns to make plans work. For our clients who are in retirement or close to retirement, we typically have a bucket with 5-years of expenses set aside in short-term bonds. And that bucket is still there and we won’t need to touch their equities for five years. In many cases, we have bonds which will mature in 2023, 2024, etc. in place to fund your spending or RMD needs. So, I am happy we have the bucket strategy in place, it is working as we had planned.

We have shared some inflation investment ideas, but I think the risks to investors may be greater from the Fed. Rising rates and recession are likely in the cards as they look to slow the economy. In spite of the headlines, this will undoubtedly be different than 1981, so I’m not sure we have an exact road map of what will happen. But, I will be your guide to continue to monitor, evaluate, and recommend what steps we want to take with our investments.</