Many investors love the Federally tax-free income they receive from municipal bonds. Municipal bonds are debt securities issued by state and local governments to fund operations or special projects. Because the income an investor receives is not taxed, the after-tax return of municipal debt is often higher than the after-tax income provided by corporate bonds and bank CDs.
For example, the yield on the iShares Core US Aggregate Bond ETF (AGG) currently stands at about 2.73%. For a taxpayer subject to a 22% marginal income tax rate, the after-tax return drops to just 2.1% and is even lower as you climb into higher marginal tax brackets. Compare this to the Vanguard Tax-Exempt Bond Index Fund ETF (VTEB) which yields 2.28% federally income tax free.
An often-underappreciated item in the US income tax code deals with qualified dividends. A qualified dividend is a dividend from a common stock or a preferred stock that the filer owns for a specified minimum time period. The beauty of qualified dividends is that they are taxed at the filers long-term capital gains rate rather than as ordinary income. The following table compares ordinary income rates and long-term capital gains rates for married filing jointly returns.
Capital gains rates are not perfectly aligned with the marginal tax rates due to the Tax Cut and Jobs Act of 2017, but except for a small slice of taxable income between $78,751 and $78,950, the tax rate on long term capital gains is lower that the tax rates on other forms of taxable income.
Which brings us to the value of qualified dividend income (QDI). QDI extends to income received from preferred securities. Preferred stocks are debt-like securities issued by corporations that rank below the bond holders-- but above the stockholders-- in the event of a liquidation. The term preferred is used because the dividends on these shares must be paid in preference to dividends paid to common stock shareholders. To learn more about preferred stocks you can view the Wikipedia entry here.
The importance of this is the after-tax returns of many preferred securities held long enough to receive QDI tax treatment, are higher than rates generally available in the municipal bond market. Take the Goldman Sachs preferred A shares (GSPRA) for example. This security has a current dividend yield of 4.7%, even at the highest capital gain rate of 20% the after-tax net on this income is 3.7% or 60% more than the tax-free rate of 2.3% from VTEB.
There are some details to keep in mind; to qualify for QDI status, the security must be held for 91 days out of the 181-day period, beginning 90 days before the ex-dividend date. Because most preferred securities pay quarterly dividends, you would generally need to make your purchase the day of the preferred trade’s ex-dividend to ensure you receive favorable tax treatment.
Also, preferred issues are highly concentrated in the financial and utility sectors of the market which could lead to poor diversification. You could use exchange traded funds (ETFs) like the iShares Preferred and Income Securities ETF (PFF) or an open-end mutual fund like the Nuveen Preferred Securities and Income Fund; but be aware that not all the distributions from funds like these are considered Qualified Dividend Income. Only 62% of the distributions from PFF were eligible for QDI treatment in 2018 and usually about 60% of the Nuveen funds distributions were QDI eligible.
Still, for investors concerned with building a tax-efficient portfolio, preferred securities are certainly worth consideration.
Okay-- you just completed your income tax return for last year. You want to file it away and not worry about taxes until next year, but before you do-- take a look at your completed return to identify ways you can save tax dollars next year.
Income tax planning can add to your future net worth and your future income streams. Here is a line by line view of some of the things that good income tax planning can do to improve your financial life.
Line 10 on your new 1040 return shows your taxable income after all deductions. Knowing your marginal income tax rate is the first step to efficient income tax planning. Lowering your income taxes in the current tax year is not always the best long-term strategy, lowering your lifetime income tax liability is often much more important.
For 2019, the federal income tax brackets for individuals are:
Your marginal income tax rate is the amount you would pay on your last dollar. For example, a single person with taxable income of $84,201 would pay a 24% rate on only one dollar of income, not their total taxable income. They would in fact pay 10% on their first $9,700 of taxable income, then 12% on the next $29,775, then 22% on the next $44,725, and finally 24% on the last dollar of taxable income.
It is important to remember that the current income tax rates for individuals are scheduled to revert to the pre Tax Cuts and Jobs Act rates in 2025. Barring tax changes passed by Congress in the interim, you have six years to utilize the current brackets to your benefit.
Managing Your Income Tax Bracket
Depending on your income level, managing the income tax bracket you fall in may mean realizing extra income to take advantage of a favorable rate; or you may want to lower your taxable income to qualify for a lower tax bracket or other income tax benefits (such as Obamacare).
In my opinion the 12% bracket is extremely valuable. Married couples can have up to $78,950 of taxable income and pay no more than 12% in federal income taxes. Less than 25% of American households have taxable income above this level and I believe the odds of their marginal income tax rate falling is quite small.
If you are among the many that fall into the 12% rate, you should look for ways to pay taxes on as much income as you can without moving into the 22% bracket. Some of the things you should consider are:
Contribute to a Roth IRA or Roth 401k rather than a Traditional IRA or standard 401k account
Convert existing Traditional IRA funds to a Roth IRA
Higher marginal income tax payers will want to take the opposite approach. They’ll want to defer more income unless they anticipate being in an even higher bracket in future years. High bracket individuals will want to:
The absolute worst taxable income numbers are $200,000 for single filers and $250,000 for joint filers; along with $157,500 for single filers and $315,000 for joint filers who own their own business.
The first range, $200,000 single and $250,000 joint subjects a taxpayer to the 3.8% net investment income tax.
The second range for self employed filers of $157,500 for single and $315,000 for joint are the cutoff for the pass-through business income deduction.
Taxpayers at those levels should take aggressive steps to lower their taxable income.
Moving back up your return, line 2 and line 3 deal with investment income.
Note that these lines have been subdivided into an A and B column. The column on the left is better than the column on the right for income tax purposes.
On the left you have tax-exempt interest, which is income generated from municipal and state government entities. Municipal bond interest is generally income-tax free, although there are some taxable municipal bonds, and some municipal bond interest is subject to the Alternative Minimum Tax.
Tax-exempt interest is also added to your Adjusted Gross Income (AGI) for purposes of calculating how much of your Social Security benefits are taxed. The higher your marginal income-tax rate, the more valuable tax-exempt interest is. To determine the taxable equivalent yield of a tax-exempt security, you divide the tax-exempt yield by 1 less your marginal income tax rate.
For an investor in the 12% marginal income tax bracket, a municipal bond yielding 2.5% gives them the same after-tax return as a taxable security that yields 2.8% (.025/ (1-.12)). For an investor in the 32% tax bracket the same 2.5% yield from a municipal bond equates to a 3.6% taxable yield.
Again, the column on the left is more valuable than the column on the right. A qualified dividend is a dividend from a company that: a) trades publicly on a US exchange and b) is incorporated in a US possession or c) is eligible for the benefits of a comprehensive income-tax treaty with the US. The advantage to generating qualified dividend income is that these payments are taxed at your capital gains rate, which is generally much lower than the rate on your ordinary income
Dividends from REITs, MLPs, employee stock options, tax-exempt organizations, money market accounts, and shares used for hedging are not eligible for qualified dividend status.
Make sure to also consider the treatment of preferred stock dividends. Although ranked below bondholders in the event of financial difficulty, preferred stock pay yields that are similar to long-term bonds. All taxpayers should consider these securities against table bond holdings for the tax advantages alone.
IRAs, Pensions, and Annuities
Income received from pensions and some annuities are absolute, in that you receive the income and you pay the taxes; however, income from an IRA and certain types of annuities are somewhat discretionary. You can plan the timing and the amount you withdraw to achieve the best income-tax outcome for your personal needs. If you are over 70 ½, you are required to take some distributions from your traditional IRA accounts (required minimum distributions/RMDs), but even then you can take advantage of the Qualified Charitable Distribution rules to lower the amount that is reported to the IRS.
Income derived from variable annuities can be problematic for some. All income from variable annuities is considered ordinary income until you have spent down those assets to your cost basis. At that point, the withdrawals are deemed to be return of principal and are no longer subject to income taxes.
Although we prefer to use IRA to Roth IRA conversions to manage income tax brackets for those in the 12% marginal tax bracket, you can certainly use variable annuities in a similar fashion. If you are in a higher marginal tax bracket, you can also consider exchanging your variable annuity for an immediate annuity. Doing this will change the deemed ordinary income rule to a pro-rata distribution rule, where some of your distribution is considered ordinary income and some of it is considered a return of principal.
You probably will pay taxes on some of your Social Security benefits. If your total income is more than $25,000 but less than $34,000 for individuals; or $32,000 but less than $44,000 for joint filers, you will pay income tax on 50% of your Social Security benefit. If you are above those ranges, you’ll pay income tax on 85% of your Social Security benefit.
Sadly, I have to say I have seen cases where an individual is less than 70 years old, in a 30%+ marginal income-tax bracket, saving money, and still insists on claiming their Social Security benefit. It would be a simple fix to suspend Social Security benefits, reduce their taxable income, and accrue delayed filing credits to their future social security income. Yet some will still continue those benefits because they feel they have paid in all their life and want to see some return on their money. Yes, you could die, but throwing away money paying needless taxes is hard to understand.
Additional Income and Adjustments
In trying to make the form 1040 look simpler, the IRS added this line. It refers to a Schedule 1 and is attached to your 1040.
Under the old tax rules, alimony was deductible to the payer and taxable to the payee. No more--Congress has managed to shift the income tax burden for alimony payments to what is likely the higher earner with the higher marginal income tax rate. If you are divorcing it is important that the income tax liability of alimony payments be considered in developing an equitable settlement.
This has become a much more important item than in years past, as owners of any business that uses a pass-through entity can receive a 20% reduction to taxable income generated through that business. Assuring you maximize this important benefit is essential. See our previous post ‘Big Savings for Self-Employed and Business Owners’.
Capital Gains and Losses
For all taxpayers, it is important to use tax-efficient strategies for taxable investment accounts. High yield stocks and bonds are more efficient being owned in tax advantaged accounts (401ks, IRAs, Roth IRAs etc), while investments that mostly appreciate in value are a better fit for taxable accounts. Still, capital gains rates are attractive relative to the tax rates on ordinary income.
You can use capital losses to offset any capital gains you receive, plus $3,000 of ordinary income. Capital losses are never a good thing, but at the end of each year you should review your investments to look for opportunities to offset gains.
Rental Real Estate, Royalties, Partnerships, S-Corps, trusts, etc.
If you own rental properties you know how helpful depreciation can be for your income tax liability. Yes, some of the depreciation will be needed to maintain the property, but some of it will also reduce your taxable income, and if you sell, will result in more income being taxed as capital gains at currently favorable rates. If you own a property that has been fully depreciated you might consider using a tax-free exchange to like property to increase your basis and start the depreciation process all over again.
Adjustments to Income
Health Savings Accounts
Many American’s are now covered by high-deductible health insurance plans either through their employer or purchased directly from insurers through the Affordable Care Act Marketplace. Contributing to an HSA will reduce your current income tax liability, and if the funds are used to pay for qualified medical expenses the distributions are tax-free as well. See our post on ‘Hacking Your Health Savings Account’.
Self Employed SEP, SIMPLE, and Qualified Plans
An easy way to reduce your current year income tax liability is to contribute to a retirement plan. IRA contributions are reported on line 32, but if you’re self-employed you can defer taxes on even more money. You can establish a SIMPLE retirement plan before October 31 of the current tax year and defer up to $13,000 ($16,000 if you are over age 50) annually.
A SEP retirement plan allows an even bigger tax deferred contribution of up to $56,000, plus a catch-up contribution of $6,000 if you are over age 50. Another useful benefit is you have until your income tax filing deadline, plus any extension, to establish and fund a SEP for the previous tax year. If you’re a business owner who still needs to reduce your previous years taxable income-- this is your chance!
Self Employed Health Insurance Deduction
If you’re self-employed, this is where you get to reduce some of your taxable income for health insurance expenses. If you’re not self-employed and are not covered by an employer health insurance plan, this is motivation for starting a side gig.
For example, the mechanic that works on cars after hours, or maybe the carpenter that does an occasional job on the side. Formalize your business to take advantage of this deduction.
While this is far from an exhaustive list of ways to reduce your income tax liability both now and in the future, you can see there are opportunities for almost everyone to benefit from income tax planning. Take some additional time to review the tax forms you just filed or see a financial planning professional-- there is a lot at stake.
Part of Oak Street Advisors’ 10 Financial Commandments for Millennials series, we discuss when to open a taxable investment account and how to strategize the location of your investment vehicles based on account taxability characteristics.
Once you’ve filled up all your tax-deferred and tax-free investment accounts, it’s time to start paying Uncle Same (now) to invest. The 9th Financial Commandment for Millennials is to open a taxable investment account, while keeping tax management a key feature of this aspect of your portfolio.
Investors need not worry about dividends, interest, or gains in a 401k, 403b, 457, SEP or Traditional IRAs because those will be taxed when you decide to have them taxed (or an annual portion is taxed when the government says so via Required Minimum Distributions at age 70 ½). Gains, dividends and interest in Roth IRAs are tax-free if you meet certain qualifications. For this reason, its best to have growth, dividend, and other income producing investment held inside these accounts.
Now that you’re opening a taxable investment account, any growth, dividend, interest or other income is taxed in the year the gains are realized or the dividend and interest is paid (usually…i.e. phantom income). While you can use long-term capital gains tax rates to your advantage on investments held over a year, the ideal goal for a taxable account is to participate in investment growth while also not being taxed left and right for gains and income produced.
To accomplish this, we recommend using a portfolio made up of Exchange Traded Funds (ETFs). ETFs offer broad diversification that reduce the need for trading, minimize taxable distributions, and provide the long-term growth you want in a tax-efficient manner. Here’s an example of Oak Street Advisors’ FatPitch ETF Portfolio investments:
Even better-- our clients experience $0 trading cost because of our relationship with TD Ameritrade as custodian. However, any DIYer can implement a similar ETF strategy on their own for a minimal $5-$8 per trade.
In general, investors can see less return drag from investment and tax expenses by utilizing this strategy in their taxable investment accounts. The relationship of the taxability of an investment and the taxability of the account it is held matters, and can keep dollars in your pocket. As with any investment, making sure you’re sticking to your strategy via rebalancing and reacting to market conditions, or paying someone to do so on your behalf, is crucial.
Part of Oak Street Advisors’ 10 Financial Commandments for Millennials series, we go through the advantages of paying down common and often necessary consumer debts such as car loans, mortgages, and student loan obligations.
If you’ve made it to the 8th Commandment congrats, you have established a strong financial foundation; we also know you’ve paid off your high interest credit card debt—but now it’s time to start pecking away at the larger consumer debts weighing down your net worth.
I’m referring to debt typically considered “necessary” for most Americans—student loans, your mortgage, car loans, business loans etc. These are loans with normally reasonable interest rates and longer payoff schedules. Paying them down may seem almost unattainable but be assured, if you commit to doing so you will save a lot of money.
For example: adding $100/month to a $500,000 mortgage at 4.5% interest will save $36,240 over 30 years. That seems abstract, like you will never really see that savings—but your net worth doesn’t lie.
What Should You Start Paying Down First?
We discuss the two different debt payoff methods in Getting Out of Credit Card Debt: The 2nd Financial Commandment for Millennials. Our advisors tend to favor the Snowball Method, so we’d recommend starting with the smallest loan first.
The thinking is as follows; Paying off a car note early not only saves interest but also increases monthly cash flow by eliminating the monthly car payment. The money that would have been allocated to the car payment can now be used to pay down student loans or add monthly principle additions to the mortgage.
Paying down your mortgage or student loans is not sexy financial planning advice—but doesn’t saving tens of thousands of dollars and eliminating all debt down sounds pretty awesome?
Over the course of my thirty-year career in the financial services industry I have seen and continue to hear many investment theses. Some brilliant, some not so much so. I have also witnessed a number of changes that in retrospect were obvious and inevitable. The personal computer revolution was one of the first. I recall there were many would be winners that vanished into dust, but some of the early players like Intel, Microsoft, and Cisco became the next generation of mega-cap companies. Likewise, with the internet boom. Companies came and went, but some like Amazon and Google became behemoths. Cell phones were the stuff of dreams in my youth, but the ability to access people and information, no matter where you are, was inevitable and although early participants like Nokia and Motorola have become footnotes, Apple and Samsung have had explosive growth and rewarded investors many times over.
Recognizing inevitable change is only half of the battle for successfully profiting in new industries and market opportunities. Diversification and patience are more important long-term ingredients to financial success. If you put all your eggs in the Commodore computers basket you were a loser. The same for eToys.com or Lycos, or Palm Inc. Even if you recognized the inevitable, it was still much too easy to lose all or most of your investment.
Perhaps, though you were bright enough or lucky enough to pick the winners. On 3/24/1980 you could have bought Intel for just $0.32 adjusted for splits. By 10/20/1980 it had already soared 56% to $0.50. A year later, the price had fallen about 48% to just $0.26 per share. Would you have held on? Would you still have faith that this was inevitable? It wasn’t until the second quarter of 1983 that Intel reached that $0.50 peak again. Today, no one gets very excited about Intel, but the stock price has reached $51 per share netting those long-term patient investors $100,000 for every $1,000 they invested nearly 40 years ago.
So, although you can find inevitable investment opportunities, today the rush of the quick pop in price per share will not always be there. Sometimes, it is just waiting, and waiting, and waiting.
With those words of warning, we will share with you four inevitable investment opportunities we feel all investors should be considering right now.
In January of 2012, marijuana became legal for medicinal and recreational use in Colorado. In 2018, it became legal for the entire country of Canada. Around the world attitudes toward “pot” are changing rapidly. We are now witnessing the birth of an entirely new industry. We believe the opportunity is akin to the liquor industry at the end of prohibition, and we are not alone. On November 1, 2018, Constellations Brands (STZ) closed a $5 billion investment in Canadian cannabis producer Canopy Growth (CGC). On August 1, 2018, Molson-Coors (TAP) announced a joint venture with Canadian cannabis company HEXO Corp. (HEXO) to develop non-alcoholic cannabis infused beverages. Additionally, in December of 2018, Philip Morris (PM) invested $2.4 billion in the Canadian cannabis company Cronos (CRON). What do these large multi-national companies see in the future of the cannabis market?
Take a look at some of the numbers.
In four and a half years, total sales of cannabis have more than doubled in the state of Colorado, jumping from $683 million to over $1.5 billion. Colorado ranks 21st in the US by population with about 5.7 million residents. That works out to sales of about $263 per year per person.
There are now ten states in the US where cannabis is legal for both medicinal and recreational use. This includes California, ranked number 1 by population and Michigan ranked number 10. These states in aggregate have a population of about 80 million. Throw in New Jersey and New York who are likely to follow suit and that means about one third of American’s live in states where cannabis is legal.
Even if Colorado is an outlier and sales in other states are only say 70% as high (haha) or $184 per person that works out to a market of $14 billion. Maybe Constellation Brands and Molson-Coors envision a day when you stop by your local pub for a cannabis infused drink rather than a beer. For comparison, the US market for beer topped $35 billion in 2018. Like the acceptance of the lottery, there will be many states reluctant to join the party for moral reasons, but sooner or later acceptance is inevitable.
No, you don’t have to be a tree hugger to realize that renewable energy is inevitable. Take a look at this chart from Yahoo Finance showing the fastest growing jobs in every state.
In eight states, the fastest growing job is solar panel installer. In four states, the fastest growing job is wind turbine service technician.
Climate change concerns aside, it is obvious renewable energy is becoming a much bigger deal both in the US and abroad. Although, starting from a low base the following chart from the Yale School of Forestry illustrates the beginnings of an explosive growth in solar energy production worldwide.
Much like the tipping point in software adoption, we believe solar installation will reach a critical mass that will one day lead to a distributed production model for energy use. With a large installed base of photovoltaic solar panels, today’s electric utility could evolve into a sort of common carrier like the Telcos, moving electricity from areas of high production to areas of high consumption. Your rooftop solar array and the arrays across the nation would provide power for homes and factories across the country. Rather than spending most of their capital on new power generation assets, they might spend more on upgrading and improving the efficiency of our electric grid instead.
Both utility scale solar and wind systems currently provide the lowest power costs available. As photovoltaic systems improve, and manufacturing systems evolve, the price will head only one way – down, as illustrated in this chart from Lazard on levelized energy costs.
You have likely heard about the Tesla (TSLA) cars with autopilot, or maybe Google’s Waymo division. The first generation of self-driving vehicles is nearly here, and it means big change for the entire transportation industry. It will change the way automobiles are used, change the ways roads are built, and change the way freight is shipped.
Like most people in America, you own a car that sits parked in your garage or at your place of employment 90% of the time. Cars are expensive. There was a time when the average family could buy a vehicle and pay for that vehicle with three-year financing. Today dealers are stretching that financing out to six or even seven years to make ownership possible.
Imagine getting up in the morning and using a smartphone app, you summon your ride to work. On the way you are free to check your email, read the news, or even just nap because you are not driving the vehicle - it is driving itself. In 2018, the average payment for a new car in the US was $523 per month. That doesn’t include insurance, fuel, or maintenance. It is easy to guess that the total cost of car ownership to be around $700 per month. With autonomous vehicles, you would pay only for the time you are using the vehicle and various companies would own fleets of vehicles around the country. They would pay for the maintenance and insurance, you would just rent a ride. Again, once critical mass is reached with autonomous vehicle adoption, our roads would become safer, parking garages would go the way of payphones, and travel becomes less frustrating. How many traffic jams would be eliminated if crashes were rare and rubbernecking were eliminated?
Shipping freight will change radically as well. Without the need for human drivers, shipping companies would program their trucks for fuel efficiency rather than speed. Trucks would travel the highways 24/7. If you have ever been on an interstate highway in the wee hours of the morning, you know there is almost no one using the highway. This becomes prime time for shippers, resulting in less congested roads and decreased need for new road construction.
For all these reasons and more, we see autonomous vehicles as an inevitable change.
The Wilshire 5000
Yep, it’s as simple as that. History has shown that investing is common stocks for the long run inevitably creates wealth. Markets go down but they do not stay down. You don’t have to be a genius or a prognosticator to participate and profit from the inevitable growth generated by a group of great American companies.
Back to our question about Intel. Did you buy it? Did you hold it? The Wilshire Index did. Same for Apple, Netflix, Tesla, and many other great and not so great companies. Some companies that were in the index disappeared, but the growth of market value marched on anyway.
The Wilshire 5000 Index is a market cap weighted index of all the actively traded stock on all the US exchanges. Originally named the 5000 because when the index was first constructed in 1977, there were about 5,000 companies actively traded in the US. As of June 30, 2018, there were 3,486 companies in the index. You will find the components of all the inevitable trends we covered here, and some that we may not be aware of included in the index. If new companies come to market in the future, they will be added too. The companies in the index are updated monthly to include IPOs and corporate spinoffs and also to remove companies that move to the pink sheets or cease to trade actively.
Part of Oak Street Advisors’ 10 Financial Commandments for Millennials series, we discuss the advantages a Roth IRA presents for young investors. From tax-free compound growth to backdoor Roth IRA contributions— we explain why young investors need to use Roth IRAs regardless of their income level.
The 7th Financial Commandments for Millennials is to max our Roth IRA contributions. Roth IRA accounts have been available since 1997. Unlike a Traditional IRA, Roth IRA contributions are taxed in the year of the contribution but never taxed again if certain requirements are met.
The magic of compounding means, the earlier you start, the greater the tax-free growth within the account. If you are 20 when you start making contributions, you could be looking at four doubles of your original contribution by the time you retire at age 60. That means a $6,000 contribution this year could grow to $96,000, creating $90,000 of tax-free income for your retirement years.
With today’s historically low income-tax rates, it would be prudent to put as much money as one can into a Roth IRA. Always consult your CPA before making this decision, but one could argue the tax-free growth and withdrawals outweigh the hurt of paying today’s top tax rates.
The 5 Year Rule
Another reason to open a Roth IRA is the flexibility it can provide to fund emergencies that may arise over your life.
You can always withdraw any Roth IRA contributions without taxes, after all, you paid income tax on the money prior to making the contribution. However, if you haven’t had the Roth IRA open for at least five years, your distribution could still be subject to a 10% tax penalty, similar to the early withdrawal penalty for Traditional IRAs.
The five years for withdrawals begins when you open the account, not when you make subsequent contributions. There is also a five-year rule for Roth IRA conversions that start in January of the year you make a conversion; this prevents someone from using a Roth IRA conversion to avoid early distribution penalties from early Traditional IRA withdrawals.
Who Qualifies for a Roth IRA
If you have a modified adjusted gross income of less than $122,000 if single, or less than $193,000 if married filing jointly, you can make Roth IRA contributions of 100% of your income up to $6,000 if younger than age 50 or $7,000 if age 50 or older.
Back-Door Roth IRA Contributions
Without income limitations for converting assets in a Traditional IRA to a Roth IRA, many who are disqualified for income resort to the back-door method for funding a Roth IRA. This works because anyone may open and contribute to a non-deductible Traditional IRA, even if you are covered by a qualified retirement plan.
Once the funds are deposited into the non-deductible Traditional IRA, they can then be converted to a Roth IRA. This has the same net income-tax effect as contributing directly to a Roth IRA. The IRS recently loosened the back-door conversion rules and allow for immediate conversions, where in the past investors were recommended to wait a few months before converting to satisfy the IRS.
The Younger, The Better
Tax-free growth and tax-free distributions are very enticing, especially for young investors. The more time your account grows tax-free, the better. Another point to make is that the more of your nest egg you have in a Roth IRA, the less your Required Minimum Distributions (RMDs) will be during retirement. Which inherently leads to you and your financial advisor having more ability to control/minimize income taxes during retirement years.
A health savings account is a tax-deductible savings plan for individuals covered by a qualified High-Deductible Health Plan (HDHP). This program allows for tax deductible contributions to a special account that allows you to pay for expenses your insurance plan does not cover with pretax and tax-free dollars.
A high deductible plan for 2019 requires a minimum deductible of $1,350 for individuals and/or $2,700 for a family. These plans must have a maximum out-of-pocket expense of at least $6,750 for an individual and $13,500 for a family.
If you’re covered by a spouse’s workplace policy, Tricare, the Veterans Administration, or Medicare you are not eligible. If you are a dependent on someone else’s tax return or covered by a Flexible spending account or Health reimbursement account, you are not eligible.
How an HSA Works
The beauty of an HSA is you make contributions that are deducted from your taxable income, yet when you spend the money for qualified expenses, the distribution is tax-free as well. Any growth within the HSA account is also tax-free. So, the contributions are deductible like a Traditional IRA, but earnings and distributions are tax-free, like a Roth IRA – you get the best of both worlds!
Contributions to an HSA are deductible from your taxable income in the years you contribute, and like a Traditional IRA, you can make contributions until April the 15th or your normal tax filing deadline of the following year. For 2019, the maximum HSA contribution is $3,500 for and individual and $7,000 for a family, with an additional $1,000 per year “catch-up” contribution for those over age 55. It is important to know that for married couples the $1,000 catch-up provision applies to each spouse. If you and your spouse are each over 55 your HSA contribution limit for 2019 would be $9,000.
If you contribute to an HSA plan through your employer, your annual contributions are reduced dollar-for-dollar by any contributions your employer makes on your behalf. For example, if you and your spouse are under age 55 and your employer makes a $1,200 annual contribution on your behalf, you would only be allowed to contribute and deduct from your taxable income $5,800 for 2019 ($7,000 contribution limit minus $1,200 employer contribution).
If you drop out of a high deductible plan before the end of any calendar year, say you become eligible for Medicare, or you change employers and the new coverage does not qualify as a high deductible plan, your contributions for that year are simply pro-rated. Meaning if you participate for three months then changed to a plan that is not eligible for HSA contributions, you would be eligible for a 3/12ths deduction in that calendar year.
On the other hand, if you become eligible for HSA contributions during a calendar year, you can make contributions as if you were covered by a high-deductible plan for the full year. So, if you moved from an employer plan that was not HSA compliant to another employer plan that was HSA eligible in October you would be allowed to contribute as if you were eligible for the entire year. This is known as the last month rule.
The contribution rules for HSA accounts also allow others to contribute to the account on your behalf. For example, if you have a working child who is covered by an HSA compliant insurance policy, you can contribute directly to the account for them. The contribution is considered a gift so you will not receive an income tax deduction, but it may be an important step to helping your child become financially stable.
Qualified HSA Funding Distribution
An important funding technique is the ability to make a trustee to trustee transfer from an IRA into your HSA account. Each taxpayer may only do one qualified transfer in their lifetime and the amount of your HSA contribution will be reduced dollar-for-dollar in the year you make a conversion. This is an outstanding opportunity to convert dollars that are potentially taxable in the future to dollars that can be tax-free. If you are young and make a conversion, the potential for tax free growth can’t be beat. Even if you’re just shy of Medicare eligibility, the income tax savings of this strategy make it worthy of consideration.
An important note for couples is that only one person can own an HSA account. To maximize the Qualified HSA funding distribution benefit, one spouse will open a family HSA for a calendar year and use their qualified funding distribution. In the following year the other spouse will open a separate HSA account and use their own once in a lifetime qualified funding distribution to fund that account. This would allow a couple to convert up to $18,000 from IRAs where distributions are likely to be taxable--into HSA accounts that compound tax-free and provide tax-free future benefits.
You are allowed to rollover funds, via a trustee-to-trustee transfer, from one HSA account to another without triggering a taxable event. This means if you leave an employer’s plan and wish to establish an HSA account through a different provider, you can consolidate your account with the new provider and simplify your finances. Or if you wish you can change HSA account custodians anytime.
If you name your spouse as the beneficiary of your HSA account, the account will be treated as the spouse’s HSA upon your death. For other beneficiaries, the fair market value becomes a taxable distribution to the beneficiary.
Funds from your HSA account can be used for qualified medical expenses for you and your family. The IRS is a bit liberal in their definition of family. Anyone who qualifies as a dependent on your income tax return can have medical expenses paid from your HSA account. You, your spouse, your children under age 19 or under age 24 if a full-time student, grandchildren, parents, and foster children are all included.
Medically necessary expenses not covered by insurance can be paid from your HSA account without taxation. Even things like drug and alcohol rehab, home modifications for disabilities, acupuncture, dental and vision care, and over the counter drugs prescribed by your doctor, are all allowed expenses.
Although your current insurance premiums cannot be paid from you HSA account, you can use those funds to pay for Long-Term Care insurance and Medicare Part B and Part D premiums.
For a complete listing of eligible expenses see IRS publication 502.
Look Back Provision
If you have an HSA account open during any tax year and do not have enough money contributed to cover all the allowed reimbursements, you can use future years contributions to pay yourself back. For example; In 2018 you had an HSA balance of $4,000 but in December you had a large unexpected $5,000 medical expense. You would be able to make 2019 contributions and then reimburse yourself for the extra $1,000 expense you incurred in 2018.
Like IRA accounts, there are certain transactions that are prohibited inside your HSA account. You cannot have any self-dealing transactions such as sale leasing or exchange of property between yourself and your HSA account, you cannot charge your HSA account for services you provide, and you cannot use your HSA account as collateral for any loans. A violation of these rules will trigger a deemed distribution from your HSA account and subject all the funds to taxation in the year the violation occurs. For more information on prohibited transactions see section 4975 of the tax code.
For the full IRS guidance on Health Savings Accounts see Publication 969.
The 6th Financial Commandment for Millennials: When it's (Not) Smart to Max Out Your Retirement Plan
Whether you’re enrolled in an employer retirement plan like a 401k, are self-employed and can utilize a SEP or Solo 401k, or are forced to brave it alone and contribute to a personal IRA – and you’ve completed the previous Financial Commandments for Millennials it's time to start making the maximum contributions to these plans.
First things first, regardless of how your 401k or other employer plan’s investments and fees are structured, investors should always contribute enough to their employer retirement plans to receive the full employer matching…aka the free money.
After that, don’t max out your contributions blindly. There are a number of factors that should be considered when determining where your savings should be invested, and an employer retirement plan should be analyzed just as thoroughly as any other investment vehicle.
For example, a low earner with access to a poorly constructed and expensive 401k plan may find it more advantageous to only contribute enough to receive the full employer matching (free money), while making the remainder of their contributions to a Traditional or Roth IRA that offers full diversification with lower fees; at least until they reach maximum IRA contributions.
If the same investor is a high earner, eating those high expenses might be worth it. Inherently, these investors have more excess income to be deferred in the first place. If they’re in the 32% tax bracket currently, they may want to defer income until they retire in a few years and their tax bracket drops to 22%. In this scenario, the tax savings may outweigh the high costs of the 401k plan.
The bottom line is that everyone’s circumstances are different and investors need to be aware that just because they have access to a 401k plan doesn’t mean it’s always the best investment option.
If you’re not sure if you’re 401k or other employer retirement plan is serving your best interest, download our 401k Like A Boss workbook. We walk you through selecting the best investments in your plan, as well as guidance on how to allocate your portfolio as well.
Ideally, you’d want to see total expenses equal to or less than 1%; anything near or above 1.5% should give you cause for concern. You can also reach out to a fee-only financial advisor who can help you determine your plan’s fees and the best investment strategy for your personal situation.
You could also ask for a copy of your plan’s 408(b)(2) and 405(a)5 fee disclosures and fund expense breakdown to find out.
Once you determine the best vehicle(s) to make your contributions, how should you invest it? You can refer to last month’s article Asset Allocation and Risk Tolerance or you can access Oak Street Advisors’ 401k Like a Boss employer plan investment strategy workbook as a starting point.
Wow! 2018 went out with a huge rise in volatility as stocks swung from a small gain for the year to nearly reaching bear market territory, before rebounding yet again to end the year down 4.38% as measured by the S&P 500 index
For 2019, you should expect volatility to remain high. Markets will continue to gyrate as we face increasing political uncertainty. The government shutdown will likely become an extended event, as neither side is likely to move much, and negotiating with the executive branch is like trying to eat Jell-O with chopsticks; it wiggles all over the place. While some may find these tactics a refreshing change to the way our government usually works, the markets are likely to be confused by the new normal and react with wild swings based on the latest news cycle. The unpredictability of the current administration will continue to promote volatility as markets react to a constant barrage of headlines and unconventional political tactics.
The Federal Reserve raised rates 4 times in 2018, moving the benchmark short-term rate from 1.25% to 2.25%. This resulted in a difficult year for bond investors as fixed income indices fell for the first time since 2013.
There is also concern about the yield curve. While the yield curve has not inverted yet, it is dangerously close to doing so. The chart below shows the 10-year treasury yield minus the 2-year treasury yield, going back to the 1970s. The shaded areas represent recessions. Historically, an inverted yield curve has presaged recessions and Fed economist David Andolfatto recently argued that an inverted yield curve could actually cause recessions. Regardless of whether an inverted yield curve is a leading indicator or a contributing factor to recessions, being on the cliff’s edge as we are now adds to the uncertainty surrounding markets going into 2019.
With worries about a possible recession on investors minds, credit quality spreads are finally normalizing after years of compression following the credit crunch of 2008-2009.
2019 may be the year we finally find some value in high-yield bonds after nearly a decade of tightened credit quality spreads.
Rising interest rates also leads to a stronger dollar. This makes US produced goods more expensive for foreign buyers and can dampen the earnings of US exporters.
After a fast start in early 2018, the equity markets fell hard in the 4th quarter of the year. Nearly every subcategory of the market ended 2018 in the red.
But compared to one year ago, equity valuations have fallen, based on many metrics.
Have equity valuations fallen enough to make stocks a compelling value? No one knows for sure, but investors should keep in mind that their default position should always be to remain fully invested. Remember, the price of the long-term gains historically inherent in the equity markets is the short-term pain caused by corrections along the way.
Investor sentiment remains muted, offering more good news for contrarian investors.
Earnings among the companies in the S&P 500 continues to grow at a torrid pace. Lower corporate tax rates have fueled stock buyback programs that allow corporate earnings per share to grow faster than the economic growth generated by normal business operations. I would expect to see a slowdown in the rate of earnings growth later in 2019, as year over year comparisons get tougher, and interest rate increases continue to take a toll on earnings growth. That does not mean we expect earnings to fall, just that the rate of growth will moderate as 2019 progresses.
2018 was also something of a dud for foreign stock investors. Developed markets produced even lower returns for US investors than did the domestic market.
And emerging markets were equally as disappointing.
For 2019, we expect both trends to continue. Higher interest rates will generally lead to a stronger dollar and a stronger headwind for non-dollar denominated investments. In 2018, the dollar rose by about 3.5% versus the Euro and about 5% versus the Chinese Yuan. That means investors in the Eurozone needed a 3.5% gain to remain even when they convert their Euro based investments back to US dollars and investors in Chinese companies had a 5% hurdle to clear.
At this point we believe investors should focus on US based companies and remain fully invested. Bond durations should remain short, at least for the first half of 2019, as Fed policy is still unclear. If the yield curve does invert, we would take that as a sign to lengthen bond maturities and perhaps reduce our equity holding a bit. You should expect volatility to remain elevated and look at dips as an opportunity.
Important: This is not intended as investment advice. We share this so that our clients and prospective clients can understand some of the factors we consider as we implement their investment strategy. Any predictions of future events should be viewed with a skeptical eye.
The 5th Financial Commandment for Millennials: Implementing the Right Asset Allocation for Your Risk Tolerance
Asset Allocation & Risk Tolerance
Part of Oak Street Advisors’ 10 Financial Commandments for Millennials series, understanding risk tolerance, asset allocation, and their relationship, is the foundation of modern portfolio theory. Implementing the proper asset allocation to minimize risk, while still achieving your long-term goals, is crucial to your success and peace of mind.
Asset allocation means: how much…of what asset.
What are Asset Classes?
There are 3 basic Asset Classes
You could add real estate, commodities, alternatives, and other investments to this list, but for simplicity we’ll stick with these main 3 classes.
Asset allocation refers to the weight of each of these asset classes in a portfolio. Here’s a generic look at how we currently allocate the different asset classes:
For example, at Oak Street Advisors we use the following asset allocation for someone who has a Moderate Risk Tolerance:
Stocks = 60%
Bonds = 30%
Cash = 10%
This asset allocation leaves a good portion of weight to bonds and cash; which is less risky than an Aggressive Risk Tolerance:
Stocks = 95%
Bonds = 0%
Cash = 5%
As you can see, with 95% stocks, and stocks being riskier than bonds and cash positions, the latter allocation is much riskier than the former.
The reason for using asset allocation is to manage risk inside your portfolio. The more stocks you own, the more volatility your portfolio will experience. The more stock you own, the higher your return has historically been. We add bonds and cash to the mix to make the short-term swings in the overall portfolio value smaller, but in doing this we also reduce the potential returns provided by the portfolio as well.
We use asset allocation to allow ourselves to stay invested for the long-term gains while sleeping well at night during times when stocks temporarily fall. Your personal asset allocation will reflect your Risk Tolerance, which can be viewed as the point where you can stay invested for the long-term gains, without making the big mistake of selling in a panic.
For some of our clients, we provide them with a short Risk Tolerance Scorecard. While brief and simplified, it gives investors a start on their comfort with investment risk. Once a risk tolerance score is determined, investors can select the appropriate asset allocation based on their individual or combined familial results. While you’re here, why don’t you determine a base-line risk tolerance by answering the following:
Grading Your Risk Tolerance:
Starting from the top down, assign the number of points from 5 to 1.
What is your current age?
Less Than 45 = 5 Points
45 to 55 = 4 Points
56 to 65 = 3 Points
66 to 75 = 2 Points
Older than 75 = 1 Point
Each question is graded the same, 5 points for the first answer, 4 points for the second answer, 3 points for the third, 2 points for the fourth, and 1 point for the last.
Write all your points down, then add them together.
An idea of your risk tolerance is estimated from the sum of your points as follows:
1-14 = Conservative
15-21 = Moderate
22-28 = Moderately Aggressive
29-35 = Aggressive
Remembering the asset allocations from above, you can select the corresponding allocation.
Inside those asset classes is an investment manager’s secret sauce, but any investor can achieve these general allocations via indexed ETFs.
One last point I want to present is the fact that yes, you can determine a proper asset allocation based on your personal risk tolerance; however, is that level of risk going to produce the returns necessary to meet your long-term goals? Sometimes investors must take more risk than they may be quantifiably comfortable with in order to achieve the desired outcome.