Q: For the first time ever, my tax preparer has asked us to make estimated tax payments each quarter. Can you help me understand why this is important?
A: Having to make estimated tax payments for the first time can be a little perplexing. Most people are used to paying their taxes through some sort of automatic “tax withholding” mechanism, such as your wages, IRA, pension, or Social Security.
Some people, however, receive income that isn’t subject to any tax withholding. Of course, the government still expects you to pay taxes on that income evenly throughout the year. Examples of this type of income might include self-employment income, rental income, interest, dividends or capital gains.
Generally-speaking, to satisfy the government, you need to pay at least 90% of your tax obligations for the year or, alternatively, 100% of your prior year’s tax. If you fail to pay these minimum levels of taxes, you could end up paying both interest and penalties.
To avoid this, you should follow your tax preparer’s advice and use your vouchers to pay those estimated quarterly tax payments by the due dates.
Q: With last year’s decline in bonds rivaling the drop in stocks, I’m really wondering if they even make sense for me. What’s the upside of keeping them in my portfolio?
A: When you invest in bonds, you are basically acting as the bank. You are lending money on set terms; the interest rate you’ll earn and when you’ll get your money back. These things are written in stone, so to speak, and normally this makes bonds a much steadier segment of a balanced portfolio.
Like stocks, however, bonds also trade in the open market. This means that bonds can and do fluctuate in value. Last year, bond prices declined way, way more than usual!
In quick fashion, the Fed hiked interest rates. This made your stale, old bonds far less attractive than brand new bonds with their glimmering higher interest rates. As a result, investors did some math and, voila, your bonds fell in value. In fact, they declined just enough to put your old bonds on financially-equal footing with those brand new bonds.
Now, the bigger and faster the change in interest rates, the greater the price change for your old bonds. The change in interest rates was both very large and very fast.
But, given the set terms of bonds, you should know that the expected total return for your bond portfolio is now significantly higher. For this reason, I think the benefits of holding bonds as part of a balanced portfolio are even greater than before. And, yes, I’m fully aware that this feels like small consolation!
