Category Archives: Investment Physchology

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

Tax Planning – take the IRA distribution or defer?

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Here is another year-end tax planning issue for people taking the required minimum IRA distributions:

Do you defer as the 2009 law allows or do you take it now because tax rates will be going up?

Input from Kiplingers is reprinted below.

For me the issue is alternate sources of cash flow. If you can defer, even against rising rates, that usually pays off because of the compounding of sheltered growth

However, this depends on how you have invested as well as your cash flow needs so everyone has to review

Thanks,

Steven Contact

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To Tap or Not to Tap Your IRA

You can skip your distribution this year and save on taxes.
By Mary Beth Franklin, Senior Editor, Kiplinger’s Personal Finance
November 25, 2009

If you are at least 70½ years old, you normally must take a taxable distribution from your traditional IRA or employer-provided retirement plan by the end of the year — whether you need the money or not — or face a stiff penalty equal to half of the amount you failed to withdraw. But this year is different. Uncle Sam says you can skip your required minimum distribution for 2009. (Employees who continue working past age 70½ are not subject to mandatory distributions from their company plans until they retire, but they still must take distributions from their IRAs.)

IRA owners who turned 70½ between July 1 and December 31 would normally have to take their first distribution by April 1, 2010. But thanks to the waiver, they can skip that, too, delaying their first mandatory-distribution deadline until December 31, 2010.

Related Links

* The New Roth Rollover Rules

And if you tapped your IRA earlier in the year and now regret it, the usual 60-day rollover period, which allows you to redeposit the money tax- and penalty-free, has been extended to November 30. But there’s a catch: You are allowed to put one IRA withdrawal back into the account within 365 days. So if you received regular distributions every month, for example, then you can put only one of the withdrawals back in. If you received the money in a lump sum, however, then you can put it all back (including any taxes withheld from the distribution; otherwise it will be considered a distribution and will be taxed as ordinary income).

The one-year moratorium on mandatory distributions also applies to owners of inherited IRAs and other retirement accounts. For example, if you inherited your mother’s IRA and planned to take annual distributions based on your own life expectancy, you can forgo this year’s withdrawal. Or if you follow another set of distribution rules that require you to empty an inherited IRA by the end of the fifth year after the owner’s death, you now have an additional year to do so.

Although there are no required minimum distributions for Roth IRA owners — regardless of age — nonspouse beneficiaries who inherit a Roth are subject to the mandatory distributions. They can skip this year’s withdrawal, too.

Of course, you can tap your traditional IRA this year if you wish and pay taxes at your ordinary rate on the entire amount you withdraw. But if you don’t need the money, there are several advantages to skipping a distribution for 2009. Keeping your money invested in a tax-deferred IRA will give your account even more to time to recover from the worst market collapse since the Great Depression. Plus, not taking an IRA distribution this year could reduce the tax bill on your other income. You might be able to trim the amount of your Social Security benefits that are taxed, and with a lower income, you may be eligible for other tax breaks that you normally can’t use, such as deducting medical expenses in excess of 7.5% of your adjusted gross income.

You can still opt to send up to $100,000 of your IRA distribution directly to a charity. While you can’t double-dip and deduct the donation as a charitable contribution, the amount will not be added to your taxable income.

Another option: Because you aren’t required to withdraw the money this year, you may want to roll some of it into a Roth IRA. (See more on Roth IRA choices here.) You’ll have to pay taxes when you make the switch, but you can take tax-free withdrawals after five years, you never have to take required minimum distributions, and you can create a tax-free inheritance for your heirs. You don’t need earned income to convert a traditional IRA to a Roth, but to qualify, your income — not counting converted amounts — can’t top $100,000 in 2009.

Tags: Roth IRAs and Roth 401(k)s Making Your Money Last, Saving for Retirement, Tax Breaks, Tax Planning

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

Steven

To convert or not – traditional IRA to Roth IRA …

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Converting a traditional IRA to a Roth IRA results in current income taxes. Also, certain taxpayers with high income cannot avail themselves of converting

If you have money outside your IRA that can cover the taxes, you are more likely to want to convert the IRA. The reason for doing so is that no taxes are due on withdrawals during retirement. Also, the asset passes to heirs with no income tax.

However, you are trading the taxes now, lessening your total investments, for future taxes. So you need to work through the decision to convert carefully

The calculation is complicated and, for example, if the traditional IRA were to be subject to taxes at a lower rate than now, converting might make sense.

A list of concerns appears below. If you are considering making this conversion and want help with the decision, let us know.

Thanks,

Steven

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First, Bob Keebler is a CPA with a major accounting firm, Baker Tilly, in Appleton, Wis., and author of The Big IRA Book. Here’s his reaction to the article:
“The math of the conversion is more complex than this author addresses:
• When rates are going down the conversion likely makes no sense.
• When rates are going up the conversion is more likely to make sense.
• Conversions are likely better for the person who does not need the funds to live off.
• Conversions are generally better for the person that has outside funds to pay the taxes.
• Conversions for a couple before the first death can make sense.
• Conversions with the intention to monitor the market often make sense.
• Conversions for a person with an estate tax problem will make more sense than for a person without an estate tax issue.
• Conversions to leave a Roth to grandchildren often have merit.
• Conversions for a person with an NOL or other carryforward can make sense.
“This question is very complex and a calculator cannot replace the professional’s judgment.”