Category Archives: Investing Risk

Rethinking Investing and Paying off Debts

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the best path may have changed ….

Investing has changed as times have changed … financial planning rules need to change too

Old thinking

In the past, when asked by a client about adding principal payments to reduce mortgage debt, so that the mortgage would be paid off sooner, I advised them to invest that payment instead.  

That advice was based on the financial planning rule that you do not pay off debt when the after-tax cost of the debt is less than the after-tax return on the investments.  Instead, you use cash flow to add to the investment because this is how you increase your net worth – the total of all investments less all debt – over time. 

Also, by not paying down your mortgage quickly, you had the added benefit of not tying up working capital in your home.  You cannot sell a bedroom when you need funds for a child going to college. 

But that was then … things are different now ….

Changes

All components of the financial planning rule need to be reevaluated:  Interest rates and inflation are at or near historic lows.  The tax law on deduction of mortgage and other interest on debts has changed.  The disruption to the economy from the Pandemic has hurt businesses and that will affect future investment returns. 

Interest rates – With interest rates so low, the investment return on cash is near zero and the return on bonds is very low.  Rates are almost certain to rise, which will make bonds today worth less in the future (when low interest bonds compete against newer bonds that offer higher interest rates, they are re-priced to match the new rate and that decreases what anyone will pay for the old bonds). 

Tax deductions – The Tax Cut and Jobs Act made the standard deduction the option for more than two-thirds of taxpayers.  With the standard deduction, there is no benefit because the mortgage interest is not actually deducted to lower your net taxes due.  That means that the after-tax cost of mortgage debt is no better than the before-tax cost. 

Investment returns – to get a better sense of the likely investment returns for that side of the rule, I spoke to Hal Hallstein IV of the Sankala Group, LLC out of Boulder, CO.  He referred me to their post on Money Supply & Discount Rates, in which they discuss the impact of stimulus checks and PPP loans in an economy where recipients are likely to invest those funds or make financial purchases because simple consumption, travel and entertainment, has been shut down.  They also discuss the threshold return required for making an investment decision, viz. the discount rate.  In the post, he states:

But simultaneously, we also know buying bonds with zero yields won’t work for people’s retirements, which realistically require 3% yields. Where does this leave us?

He then presents a rationale for owning gold, an asset he has always avoided, as have I.  But now it serves as a protection against a downturn when you have a portfolio that invests primarily in the stock market. 

In our conversation, we compared the weighted cost of capital, the blended rate on all your debt, against the expected return from investing, which he pegs at 3.5 to 4.25% over the next decade, due to high equity valuations in the US and low interest rates.* 

One note of caution: to get those returns will require tolerating substantial volatility.

All of this leads to the following:  if your mortgage is at 3.5%, and you get no deduction value, and your potential return is 3.5% before taxes, on which you will have some tax hit, now or later, then paying off the debt is a better choice financially than adding to your investments.

New planning ideas

When you apply the debt to investment rule above, more people may find it best to pay down debt. 

For a mortgage, added to your monthly payment will have a substantial impact over time, cutting the total interest paid.  If you have a Roth IRA, it may even make sense to distribute funds to pay a student loan or car loan, depending on the loan interest rate.

There are still some reasons not to switch from retirement investing to debt reduction, such as when your employer offers a match for contributions.  For a good set of considerations to review before acting, see the Betterment 5-Step Action Plan.

Conclusion

While the planning rule used to lead to the conclusion that you are best off adding to investments rather than accelerating paying off long-term debt like a mortgage or car loan, the conclusion from applying that rule has flipped.  Many will increase their net worth by paying down debt sooner. 

I hope you and your loved ones are all managing this as well as you can during the Pandemic. 

Thank you, and be well

Steven

  * Sankala Group LLC’s communications should not be considered by any client or prospective client as a solicitation or recommendation to affect any transactions in securities. Any direct communication by Sankala Group LLC with a client or prospective client will be carried out by a representative that is either registered with or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. Sankala Group LLC does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information presented in this communication, or by any unaffiliated third party. All such information is provided solely for illustrative purposes.

Steven A. Branson, retirement, investing, Financial Strategies, debt, discount rate, decision making, newsletter, cost of capital

Year-end Tax Planning, Tax Credits, and all Continued

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There are two parts to this e-mail – year-end moves for 2009 and planning for long-term capital gains rate changes over the next three years…..

First is a repetition of some year-end ideas to make sure you have addressed all that you should to save taxes, between 2009 and 2010 combined.

One idea to check out is the sales tax deduction for purchase of a large item like a new car, especially with all the sales on cars at year end. These and other ideas are reprinted from Kiplinger’s below, along with links to other articles.

Also, be careful about withholdings – some people had reductions early in 2009 and will end up owing taxes if they do not change the withholding rate now or pay an estimate

Remember to use the 2009 $13,000 gift exclusion before it expires.

Finally, you can adjust your withholdings the other way if you will have the benefit of the first-time home buyer credit or expanded tuition credit.

Second is a strategy on capital gains. As we said, this is a year for planning 2009, 2010 and 2011 taxes. The long-term capital gains rate will remain at 15% in 2010, but then the rate jumps back up to 20%. This argues for selling in 2009 or 2010 to increase the basis, buying back and then having less taxed in 2011 or later at the higher rates.

Reprinted below is a table from Wikipedia along with their description of the US Capital Gains Tax.

There are many issues raised in this Newsletter, so let me know if you have questions or comments.

Thanks,

Steven

Review Your Year-End Tax Plans

Making the right moves now can save you plenty.
By Mary Beth Franklin, Senior Editor, Kiplinger’s Personal Finance
November 17, 2009

The end of the year is fast approaching, but you can still take steps to lower your 2009 tax bill. Don’t focus just on this year, though. Look ahead to next year as well. That may help you decide whether you should take advantage of certain tax breaks due to expire at the end of this year, such as a sales-tax deduction when you buy a new car, or delay action so you can reap a tax break still available in 2010, such as claiming a tax credit of up to $1,500 for installing energy-efficient home improvements.

In general, it makes sense to accelerate as many deductible expenses into this year as possible to reduce the income that’s taxed on your 2009 return. But that’s not always the case. If you expect to be in a higher tax bracket next year, for example, you may be better off postponing some deductible expenses until 2010, when they will be worth more.

Those who itemize have plenty of leeway when it comes to shifting deductions. Start with state and local income taxes. Mail your January estimated payment in December and you can claim a deduction for the payment this year, not in 2010. (Warning: this doesn’t work if you’re subject to the alternative minimum tax. State taxes aren’t deducted under the AMT, so there’s no benefit in accelerating the payment.) Or, make your January 2010 home-mortgage payment before the end of this year and you can deduct the interest portion in 2009.

Accelerating charitable contributions planned for next year into this year will boost your itemized deductions. Just make sure your mail the check or charge the donation to your credit card by December 31 so the gift counts for 2009. And if you’re close to exceeding the threshold of 7.5% of adjusted gross income for medical expenses, consider getting and paying for elective procedures in 2009.

Sometimes you have to spend money to cash in on certain tax breaks, such as buying a first home or purchasing a new car. But pay close attention to income eligibility limits to make sure you’re able to capture these and other tax breaks. Some incentives, such as the home-energy tax credit, are not tied to your income.

In the coming weeks, we’ll be rolling out a new tax tip every weekday. You can sign up for outo have the best and latest tax information delivered right to your in-box.

Let us know if you have questions or comments. Thanks,

Steven

The Stimulus, The Bank Bailout and “debt is the new equity”

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The Stimulus Package

The stimulus package should be passed by tonight. It contains tax law changes and other benefits that may affect you, in terms of tax credits, AMT relief, education costs and the credit for first time home buyers. A good summary from the N.Y Times is reprinted below.

As for the actual stimulus of the package, many argue that it may not be enough (see the Op-Ed piece by Nobel laureate Paul Krugman, Failure to Rise, Published: February 12, 2009 at http://www.nytimes.com/2009/02/13/opinion/13krugman.html?em)

Professor Krugman argues that the government needs to find more ways to create economic production, through job creation and spending, because “will be a $2.9 trillion gap between what the economy could produce and what it will actually produce. And $800 billion, while it sounds like a lot of money, isn’t nearly enough to bridge that chasm.”

Whether it is enough or not, tracking the government response to see if jobs are created and spending resumes will be one crucial side to an economic recovery. (see the editorial at http://www.nytimes.com/2009/02/13/opinion/13fri1.html?_r=2 for more on what happens next…)

Banks, Credit and TARP II

The other side of an economic recovery is the bail out. So far, the roll out from Treasury Secretary Timothy Geithner disappointed many for its lack of detail. (see http://www.nytimes.com/2009/02/11/business/11markets.html?fta=y )

The roll out focused on more capital infusion for banks, which is important as some argue that a large number of banks are actually insolvent. However, what may be more important is that Mr. Geithener’s remarks still skirt the issue of the toxic assets.

Some of the original plans proposed buying the toxic assets. Today, no one really knows the total of bank assets that should be written off as bad (or, on the other side, which should be bought by the government-private fund …)

Until the full measure of these assets is understood, banks will continue to have trouble resuming lending at full capacity and that will hamper the recovery.

Investment Responses

So, as an investor, how do you respond? People still argue about moving to cash, but while that seems safe it (1) sells assets that are down and could recover and (2) misses upswings, like the jump in value of convertible bonds this past January.

On the other side, some argue that falling prices mean that stocks are cheap now. An advisor upon whom I rely has considered this and come away feeling that many stocks are not cheap as much as properly valued in today’s economy. Remember, if you measure stocks by the price to earnings ratio, the E of the P/E fell more than the P so that stocks are actually more expensive by this measure. (This was discussed in a conference call discussion by Mark Yusko of The Endowment Fund.)

In this recent conference call, Mr. Yusko argued that stocks are not the investment to make now because “debt is the new equity”. He has shifted from his investment focus on energy, Asian consumers, emerging markets, Japanese reflation, and health care to buying debt instruments because of the dislocation in that market.

As stated above, we do not have a clear picture of which debt assets have value and which are worthless or “toxic”. This dislocation, as he called it, or failure of the market to properly value, provides for some great opportunities. If you buy debt instruments for under 40% of their face value, you still stand to have a substantial return even if some of the debtors default. (I have made this argument before, so I will not elaborate more in this e-mail.)

Let me know if you have questions or concerns.

Good luck,

Steven

——

What’s in the Bill for You

By RON LIEBER Published: February 12, 2009 NY Times

All the talk the last couple of days about the stimulus bill was about compromise and slimming down. What is left, though, is a huge spending bill, with well over $100 billion in tax breaks and handouts for individuals.

And most of us will be able to use at least one of them, though it will be difficult to get much money immediately, unlike the stimulus checks that went out last year.

What follows is a list of some of the biggest provisions in the bill that will hit you directly in the wallet. Keep in mind that the language in the measure isn’t quite final and the Senate and House still have to vote to approve it.

INCOME TAX In 2009 and 2010, there is a tax credit of up to $400 for individuals and $800 for married couples filing their taxes jointly. You calculate your credit, subtracted from other federal taxes you owe, by taking 6.2 percent of your earned income.

Your eligibility for this credit begins to phase out if you’re an individual with an adjusted gross income over $75,000 or a couple with income higher than $150,000.

Employers may end up adjusting tax withholdings on paychecks so that this credit trickles into your bank account over the course of the year. People who are self-employed can adjust their quarterly tax filings to account for the credit.

This credit is refundable, according to a summary of the stimulus bill that the Senate Finance and House Ways and Means committees released Thursday. That means that even if you have no federal income tax liability, you will still get the money.

UNEMPLOYMENT Normally, you pay federal income taxes on federal unemployment benefits. In 2009, however, you won’t have to pay taxes on the first $2,400 in benefits you receive.

HEALTH INSURANCE If you get fired, your company is required, thanks to a law known as Cobra, to allow you to pay to keep your health insurance, generally for up to 18 months.

The problem is, it can cost you $1,000 a month or more to keep the coverage.

Now, the federal government will subsidize 65 percent of the premium for up to nine months. To be eligible, you need to have been forced out of your job between Sept. 1, 2008, and Dec. 31, 2009. Also, your income in the year you receive the subsidy cannot be more than $125,000 for individuals or $250,000 for married couples filing their taxes jointly.

If you lost your job after Sept. 1, 2008, and declined Cobra coverage, you’ll now get another chance. Call your former company in the next two months to find out how this will work.

You need not keep an eye on the mail for a subsidy check from the government, according Kathryn Bakich, senior vice president in Washington of the Segal Company, a benefits consulting firm. Instead, your former employer will collect the money from the government.

SOCIAL SECURITY In 2009 a number of retirees and disabled people, including Social Security recipients, will receive a $250 refundable tax credit. The money would arrive within 120 days of the bill’s signing.

CAR BUYER TAX DEDUCTION For the rest of 2009, you’ll be able to deduct the state and local sales and excise taxes you pay on the purchase of a new (not used) car, light truck, recreational vehicle or motorcycle.

This will be an “above-the-line deduction,” according to Clint Stretch, the managing principal of tax policy at Deloitte L.L.C. in Washington. That means that you can take it regardless of whether you itemize other deductions on your tax return.

Mark Luscombe, principal tax analyst for CCH, a tax information service, notes that state sales taxes alone can run 6 to 7 percent, before any county or local tax kicks in. That said, if you trade in a vehicle, your taxable purchase price may be lower.

Eligibility for this tax break begins to phase out for single people with adjusted gross income over $125,000 or $250,000 for married couples filing jointly. And the deduction does not apply on spending above $49,500.

PELL GRANT According to a summary from the office of House Speaker Nancy Pelosi, the maximum Pell Grant will increase by $500, to $5,350 in 2009 and $5,550 in 2010. The grants are generally for low-income students.

HIGHER EDUCATION TAX CREDIT This credit covers up to $2,500 of the cost of college tuition and other related expenses in 2009 and 2010. You’ll need to spend at least $4,000 in a single year to get the full credit. The credit begins to phase out for individual taxpayers with adjusted gross incomes over $80,000 or $160,000 for married couples filing jointly.

Forty percent of the credit is refundable, which benefits low-income students paying their way through school (who may owe no federal income taxes).

529 PLAN EXPANSION When you withdraw money from a 529 college savings plan, you can use it for tuition, room, board, books and other college expenses. In 2009 and 2010, families can also use the money for computers and computer technology, which could include educational software and Internet service for students living at home.

FIRST-TIME HOME BUYER CREDIT First-time home buyers are eligible for a refundable tax credit equal to 10 percent of the purchase price of their home, up to $8,000, if they made the purchase after Jan. 1, 2009, but before Dec. 1, 2009.

Unlike a similar credit that Congress provided last year, you don’t have to pay this one back over 15 years. The new credit, however, does phase out for individuals with incomes over $75,000 or married couples with incomes over $150,000 who file their taxes jointly. Also, you forfeit the credit if you sell the house within three years.

TRANSIT ACCOUNTS If you commute to work via public transportation, your employer may allow you to set aside pretax money from your paycheck to pay for the bus, train or parking. Currently, you can put aside only $120 a month for mass transit while those who drive and park can save $230. This year and next, those who take mass transit will also be able to put aside $230 each month.

A.M.T. PATCH Each year, Congress creates a temporary fix to keep millions of people from paying the alternative minimum tax. This year, the patch is part of the stimulus bill. “If you didn’t pay the A.M.T. last year, you probably won’t this year,” said Mr. Stretch of Deloitte. “For most people, this is a nonevent. They didn’t even realize they were in danger of being shot in the head by the A.M.T.”