Financial Insights – April 1, 2022
MARCH’S VALIANT EFFORT COMES UP SHORT
Market turbulence hit a fever pitch in the first quarter of 2022 as volatility reached levels not seen since 2020. The S&P 500 was down 8% through February as inflation concerns became (partially) overshadowed by Russia’s invasion of Ukraine. Market pessimism finally gave way to the bulls in March as the Fed pushed back against inflation by raising its benchmark interest rate for the first time since 2018, and hopes of a ceasefire agreement in Ukraine added to the rally. But it wasn’t enough. The S&P 500 finished the quarter at 4,530 for a loss of 4.60%. The Russell 2000 was down 7.53%, the Bond Index fell 5.93%, and the MSCI EAFE finished down 5.79%.
TAX DAY FAST APPROACHING – APRIL 18th
Perhaps you have already filed your taxes, or maybe you are scrambling to get it done in the next 18 days. You may request an extension of time to file your tax return, but you still need to pay your estimated taxes by April 18th.
Would you believe that many taxpayers overpay their taxes throughout the year to avoid writing a big check on Tax Day? According to Lending Tree, 46% of all taxpayers intentionally overpay and receive an average refund of $3,000.
Okay, we get it, but it is not a good financial practice because it is like giving the government an interest-free loan. Then, on top of that, with inflation running at 7%, it is worth $2,790 when it comes back to you. Take the time and make the effort to get as close as you can when estimating your tax bill. We recommend working with your tax professional to make you penalty-proof from year to year.
OOPS! DID THE FED REALLY SAY THAT?
In March 2021, the Federal Reserve predicted that it would not raise interest rates until 2023 because the inflation creeping into the economy was “transitory.” What a difference a year can make! With inflation running at a rate not seen in 40 years and not abating anytime soon, the Fed raised interest rates for the first time since 2018. They projected that they would continue to raise rates throughout this year at their meetings. Besides changing the frequency of rate increases, they are also hinting about increasing the rate hike from 25 basis points to 50 basis points at their May meeting. Though it would surprise to us if they raised rates before then because the market most likely would react negatively and the Fed probably doesn’t want to do that.
REGULAR OR ROTH IRA – WHICH IS BEST?
Before we answer the question, let’s do a quick review. You can contribute a maximum of $6,000 (under age 50) and $7,000 (over age 50) to either one or a combination of the two.
With a regular IRA, you get a tax deduction upfront and tax-deferred growth. You can’t touch the money until age 59½ without paying income tax and a 10% non-deductible penalty and at age 72, you must begin taking Required Minimum Distributions (RMD) based on a life expectancy table.
With a Roth IRA, you do not get a tax deduction, but it also grows tax-deferred. You can’t touch the earnings for five years without paying income tax and a penalty (although you can always take the contributions without tax or penalty). Unlike a regular IRA, you do not have to take any of the money during your lifetime. Each type of retirement account allows certain distribution exceptions like paying for qualified higher education costs or being a first-time homebuyer.
Which option is best? As usual, the answer is “it depends.” First, if your tax bracket today is lower than the one you expect/experience in retirement, generally the Roth IRA will produce a better result while the reverse is true for a regular IRA. If the tax rate is the same and the investment results are identical, then it doesn’t make any difference which one you use.
Next, if you believe tax rates will be higher in the future than they are today, a Roth IRA is likely a better choice. Buying a fast-growing investment in a Roth will have better results than in a regular IRA so you may want to consider riskier investments. However, last year Congress tried to limit the tax-free growth in a Roth IRA if you were above certain income limits by making the excess growth taxable. Fortunately, it didn’t pass.
If you file taxes as a single person and make over $129,000 of Modified Adjustable Gross Income (MAGI), then you will not be able to make a full contribution to a Roth IRA. There is a phase-out of your contribution amount up to $144,000 and anyone over that amount cannot contribute to a Roth IRA. However, if you are a participant in a 401(k) which allows a Roth contribution, there is no income limitation.
So, in the final analysis, “it depends.” By the way, there is nothing wrong with hedging your bet by having some of both. If you would like to discuss this in greater and more specific terms, please give us a call. Please remember, you can make an IRA or Roth IRA contribution for the previous year until Tax Day.
EVEN SMALL INFLATION CAN AFFECT RETIREMENT INCOME
Suppose you retired in 2011 and inflation affected your income at a rate of just under 2%. Therefore, a $100 Ben Franklin bill declined in purchasing power to only $81.70 this year. Now if inflation continues at 2% for the next 10 years, that same $100 would purchase only $66.75 today. The purchasing power declined by 33% over the 20 years.
What if you retired at the beginning of 2021 and inflation was 7% and the year over year rate this year is 5% and then it returns to 2% for the remaining eight years. Instead of your purchasing power is reduced to $81.70 after ten years it is now only $75.16 and at the end of 10 more years, it isn’t $66.75 but $61.41, or 8% less for only two years of bad inflation and we don’t know what it will be like after this year. Put it another way, to purchase the same goods and services for $100 today will cost almost 40% more in 20 years. Just like the sequence of returns (does it go up or down in the first few years) in the stock market at the beginning of retirement, the same is true of inflation and its impact on retirement planning.
FINDING RETURNS IN A RISING RATE ENVIRONMENT
The Fed effectively kicked off a rate hiking cycle last month as it announced the first increase to its benchmark interest rate since 2018. In an investment environment where we could see as many as ten 25 basis point increases to the federal funds rate over the next two years, we look to similar cycles in the past to see how a portfolio comprised of 60% equities and 40% fixed income would perform. The standard 60/40 portfolio produced an average annual return of approximately 5% over the last nine Fed rate hiking cycles since 1972, which is below the average annual return for all periods but certainly not paltry.
The most difficult environment for investments is stagflation which is characterized by high inflation, little to no economic growth, and high unemployment. The 60/40 portfolio average return during those periods since 1972 was approximately -3%. While we have certainly experienced some historical inflationary pressures recently, unemployment is very low and the U.S. economy is expected to grow at a healthy rate this year – helping us avoid stagflation concerns.
REAL ESTATE ISN’T COOLING OFF
Many have predicted that real estate prices would slow now that interest rates are climbing. But many real estate deals don’t involve borrowing money because they are all-cash offers.
Point in case. Just last week, one of our clients listed a small two-bedroom condo on the market for $200,000. Within 24 hours, they received an offer for $233,000. Just as they were ready to accept this offer, they received another contract for $288,000 ALL CASH, as is, and closing within four weeks.
Though we are not real estate experts, we see residential real estate staying “hot” for a while longer for two reasons. Historically, the interest rates for mortgages are still low so it will take more interest rate increases to have a meaningful impact. In addition, high demand and low supply remain the norm. The pre-pandemic inventory of homes for sale was 1.39 million on December 31, 2019. As of February 28, 2022, the inventory has dropped to 870,000, or 37% less. Simple economic rule – high demand and low supply equals higher prices.
AMERICAN WEALTH GROWS
Are you feeling wealthier? The Federal Reserve reported that America’s wealth grew by $5.3 trillion in the fourth quarter of 2020 bringing our total net worth to over $150 trillion. The strong fourth quarter in the stock market added $2.5 trillion and the overall strong real estate market contributed $1.5 trillion. That is the asset side. What about the debt side? Not counting mortgage debt, consumers added $302 billion. Of course, since the first of the year, this good news has been dampened by the Russian invasion of Ukraine, the continued pressure on the economy because of inflation, and a retreat from the record high watermark for the S&P 500.