Front Street Wealth Management

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There’s Still Time for Year-End Planning

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It certainly feels that 2021 is flying by faster than usual! As soon as they went up, our Halloween decorations will be packed away and, incredibly, Christmas will be here. Before it’s too late to think calmly, here’s a short checklist for some year-end financial planning.

Have you checked your beneficiary designations lately? There is a common misunderstanding that deserves highlighting. It’s important to remember that your beneficiary designations for your IRAs and other retirement plan accounts don’t automatically follow the distribution plan you’ve laid out in your trust. These accounts should be viewed as separate ,which means every so often it’s smart to review all your beneficiary designations.

Have you already met your health insurance deductible? If you have, it’s a good time to take care of additional health care needs you’ve been putting off. Once the calendar turns, your out-of-pocket deductible resets back to zero. For that matter, if you’ve been contributing to a “use-it-or-lose-it” flexible spending account through your employer, it’s also time to set up that eye exam or dental work. Prepare to be put on their cancellation list, of course!

Have you reviewed your charitable giving for 2021? Under the current tax law, most people don’t itemize their deductions anymore. Instead, the super-sized “standard” deduction is used by about 90% of taxpayers. Due to this, in a typical year most people don’t get any tax break for their charitable giving. But, for the past two years now Congress has added a special opportunity to get a charitable donation deduction, even if you don’t itemize on your tax return. For 2021, single filers can get a tax deduction for up to $300 in cash donations to charities and couples can deduct up to $600.

Beyond this year’s special above-the-line deduction, if you’ve reached the age where you have to take required minimum distributions from your IRA, remember that you can also meet your requirement by donating some of it directly to charities. These charitable IRA distributions will not count as taxable income. Brokerage firms can issue you a dedicated IRA checkbook to make this process much easier.

Do you know about the special 0% tax bracket? Yes, amazingly, this actually exists! However, it can be a little bit difficult to understand. If your taxable income happens to fall inside the 12% tax bracket, your dividends and realized long-term capital gains are not subject to federal taxes.

To help visualize how this works, picture a stack of bricks that represents all of your taxable income. Your dividend income and capital gains always sit on the very top of this stack. As long as your full stack of taxable income sits under about $40,000 for single filers and about $80,000 for married filers, those top bricks won’t be taxed at all. If you’ve still got some room, or can create more room, inside the 12% tax bracket, look to harvest some of your long-term capital gains at a zero federal tax rate. That’s a deal that’s too good to pass up.

Willie Sutton, Democrats and Sausage

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Democrats and President Biden are knee-deep in the political act of horse-trading and arm-twisting. It’s sausage-making at its worst. In the end, most Americans will find the result downright tasty. For the wealthiest among us, it’ll no doubt cause some financial indigestion.

In exchange for the extension of the new bulked up child tax credits, a broadening of childcare tax benefits, the expansion of Medicare benefits along with the introduction of free community college, paid sick leave and universal pre-K, a slew of tax changes are on the table.

In keeping with Biden’s election promise, most of the proposed tax hikes for individuals will only affect people who make more than $400,000 to $500,000 per year. To loosely paraphrase the famous bank robber, Willie Sutton, this is where a lot of the money is and, conveniently, where most of the voters aren’t.

To start, the top tax bracket would be about 3% higher than it is today, returning it to the familiar 39.6% level. This proposal not only increases the top tax rate, it would kick in at a lower income threshold.

Next, high-earning business owners who use S-Corps to split their earnings as partly “wage income” and partly “business profit” may face an extra 3.8% tax on the portion they choose to classify as business profit. This proposed change partially closes a loophole that helps them avoid paying Medicare taxes.

Also on the docket is a tax hike on long-term capital gains. The proposal would raise this tax to 25% from the current level of 20%. Once again, this would only affect those making over about $500,000 per year. An earlier proposal to capture capital gains taxes on inherited assets appears to have been abandoned, for now.

Rounding out the tax changes for high earners is a new 3% “surcharge” on income that exceeds $5 million as well as a slew of limitations placed on massive IRA balances above $10 million. Finally, certain Roth conversion strategies may also be a thing of the past (although some come after a 10 year delay!)

Beyond these proposed tax changes for individuals, Congress is also focused on reversing some of the corporate tax cuts introduced in 2018.

Under current proposals, the top corporate tax rate for businesses structured as C-Corps would rise from the 21% rate to around 26%. Prior to the Trump tax cuts, the top rate for big businesses was once 35%, so this change only represents a partial reversal of tax policy.

Finally, for certain business owners who conduct their activities through pass-through entities – such as S-Corps or LLCs – the lucrative 20% business income deduction will fade away if they make more than $5 million in profits.

Just as sausage-making is a notoriously unappetizing thing to watch, over the coming weeks Congress looks poised to grind out an ugly legislative process. Frankly, if it wasn’t my job to watch it all closely, I’d simply choose to avert my eyes!

Jason P. Tank, CFA, CFP® is both the owner of Front Street Wealth Management, a purely fee-only advisory firm and the founder of the Money Series, a non-profit program committed to providing open-access to financial education, for all. Contact him at (231) 947-3775, by email at Jason@FrontStreet.com and at www.FrontStreet.com

Defying the Laws of Gravity

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I suppose it’s only appropriate that billionaires like Jeff Bezos, Richard Branson and Elon Musk have taken a liking to outer space. Attempting to defy the laws of gravity is all-the-rage in financial markets, too.

The stock market is trading in rarified air. Traditional measures of value sit at historic extremes. Nonetheless, as mentioned in my last column, investors have adopted a palpable sense of calm about it. It’s as if they are relying on an invisible safety net.

It doesn’t take an investment guru to see that this safety net has been tightly woven together by the truly unconventional policies of central bankers and politicians, worldwide. The promise of super-low interest rates coupled with repeated injections of government stimulus appear to have altered the old yardsticks of value. In doing so, it is also skewing the longstanding rules of conservative investing.

Over the last few months, a change is underway within the Federal Reserve. Seeing early signs of possible economic overheating – shown in higher wages, a tight labor market, booming real estate prices and general inflation pressures – the Fed is now finally “starting to think about starting to think about” raising interest rates. This cute turn-of-phrase by current Fed Chair, Jerome Powell, represents a subtle shift in policy. It is just the first of multiple, well-telegraphed steps by the Fed in coming years. That is, if things go according to plan.

After their current thinking-about-thinking-about phase, the Fed will begin to pair back, or taper, their constant purchases of bonds. Currently, the Fed spends a colossal $120 billion per month to help pin down interest rates. Their bond purchases not only work to suppress rates, they also create a steady flow of cash into the markets and economy. Naturally, investors then embark on a semi-desperate search to earn an adequate return on this newly-injected cash.

For any conservative investor out there, the real conundrum of what to do with excess cash has encouraged a not-so-fun game of hot potato in the investment world. Faced with the prospect of earning nothing, holding onto cash is hard. Even sticking to a conservative investment approach is tough.

Based on what the Fed has been signaling to investors, they might finally stop purchasing bonds sometime in 2023. It is only after their tapering phase is complete – and they deem the economy strong enough and markets well-behaved enough – will the Fed actually start to raise short-term interest rates above zero. The actual hiking of rates will undoubtedly take a good amount of time, just as it did in the years preceding Covid.

To me, the current calm indicates that investors are banking on the idea that we’ll continue to see abnormally low interest rates and continued government stimulus for a few more years, possibly even longer. If true, the Fed and our elected officials might just be able to defy gravity for a bit longer. Safety net or not, I cannot seem to shake the idea that the air is getting awfully thin up here!

Things Are Looking Unnaturally Easy

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Investors are experiencing an unnaturally profitable period. The S&P 500 index has gained about 18% so far in 2021. And, as a reminder, this follows a similar 18% return in 2020 and the 30% surge in 2019. That’s over 80% in less than three years. After such a run, prudence really should be the order of the day.

With this run in stocks – and, let’s be honest, it feels inexplicable amidst such economic upheaval – now is a wise time to review your investment portfolio within the context of your longer-term plan. Every so often, it’s smart to take a step back and formally assess where things currently stand relative to your original plan.

There are only a few truly important rules to follow in investing. Beyond proper diversification and sticking with low-cost investments, the most important factor is your portfolio’s asset allocation.

To review, the concept of asset allocation is about finding the right mix between riskier and steadier investments. Studies have shown that your portfolio’s allocation between stocks and bonds, not your individual selections, explains the vast majority of your portfolio’s return.

Do you know your portfolio’s current asset allocation? If not, that’s a good place to start your review. You might be surprised by how much your portfolio has drifted away from your original asset allocation target. Admittedly, rebalancing in the face of possible capital gains taxes can be a difficult and delicate task. But, it’s always best to focus on the dog (your portfolio), not the tail (your tax bill.)

Next is really knowing your life’s costs. If you want, you can call this your budget. I prefer to refer to it as your living cost summary. The word, budget, just has such a restrictive ring to it. On the other hand, your living cost summary is a comprehensive tally of where you’re choosing to spend your money. That sounds much easier to stomach.

Do you know the cost of your lifestyle? Having created retirement-readiness models for over two decades, I can assure you that your spending habits will make or break your plan. Of course, as opposed to banking on a higher level of investment returns, your spending is the far more controllable and predictable piece of the puzzle.

Developing a formal retirement income model shouldn’t be seen as rocket science or feel overly painful. Thanks to today’s sophisticated financial planning software, these models have become more robust, flexible and useful over the years. At its very core, though, it’s still all about comparing your income and expenses, year-by-year, and then projecting things out over many decades and over many possible future scenarios.

Your formal financial plan really is the baseline against which all things should be measured. It’s at times like these, when markets seem almost too good to last, recalibrating both your portfolio’s asset allocation and assessing your spending against your original plan should move up your list of priorities. It might even allow you to overcome your natural sense of complacency just when things appear so unnaturally easy!

Jason P. Tank, CFA, CFP® is both the owner of Front Street Wealth Management, a purely fee-only advisory firm and the founder of the Money Series, a non-profit program committed to providing open-access to financial education, for all. Contact him at (231) 947-3775, by email at Jason@FrontStreet.com and at www.FrontStreet.com

College Savings, How Much and Where?

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Q: We have two children (ages 3 and 5) and we’d really like to plan for the cost of college. Unlike us, our hope is to leave them with as little debt as possible. What would you recommend in terms of the amount to save and the type of account to use?

A: Your children are lucky to have parents who want to plan for their future. That’s not something they’ll recognize immediately. They will someday, probably!

Addressing the “how much” question is different for every family. Some parents hope to just pay for the cost of tuition, fees and books. Some want to provide for an in-state public university. And, others hope to pay the full cost of a private college or out-of-state university. Defining the exact goal is obviously the first step.

For an in-state, public university, the cost of tuition and books are about $15,000 per year. Room and board will run you another $10,000 per year, as a very rough estimate. So, for a four-year degree, that adds up to over $100,000. And, remember, these figures are measured in today’s dollars. Keeping pace with college cost inflation is a great reason to put away money early.

In your case, with about 14 short years until college starts, providing them with four years of college might require you to save about $8,000 to $10,000 per year for each child. If this level of saving isn’t possible within your budget – and, let’s be honest, it is not for most people – it’s fine to scale back your goals. Remember, scholarships, grants and student loans are all viable financing tools. We also have a very good community college here, too.

Now, once you’ve decided on the amount you can actually save, my recommendation is to use a 529 plan for each child. The State of Michigan’s plan is called the Michigan Education Savings Program. Go to www.misaves.com to read about it.

The investment earnings inside a 529 plan are not subject to any taxes as long as the money is eventually used for “qualified” education expenses. On top of this tax benefit, your savings can result in an immediate state tax break of up to $425 per year.

Jason P. Tank, CFA is both the owner of Front Street Wealth Management, a purely fee-only advisory firm and the founder of the Money Series, a non-profit program committed to providing open-access to financial education, for all. Contact him at (231) 947-3775, by email at Jason@FrontStreet.com and at www.FrontStreet.com