Rules of thumb are helpful at distilling complex information into understandable tidbits of advice. They’re not intended to be an accurate application of all relevant information, just general guidance. The problem is that if left unchallenged long enough, rules of thumb can begin to seem like infallible truths. Helpful and important details can get glossed over or left out entirely. This happens a lot in the complex world of financial planning and investing.
Case in point is the rule of thumb that retirement savers should put as much as possible into tax-deferred accounts, like 401(k) plans and IRAs. These “traditional” accounts help folks save for retirement with the bonus of tax deductions along the way. Everybody likes a tax deduction, right? Then the account isn’t taxed until later and your savings can compound over time to create a sizeable nest egg if you play your cards right.
That’s the good part. The bad part, and what the rule of thumb glosses over, is how every dollar you withdraw in the future gets taxed as ordinary income. It glosses over mandatory distributions beginning at age 72. And it glosses over the taxes that your beneficiaries will have to pay when they ultimately withdraw. All of this is traded for the powerful incentive of a tax deduction on contributions. It works well, don’t get me wrong. But it’s imperfect.
The alternative is investing in a Roth IRA. I’m sure you’ve heard of these. They function like traditional accounts with the difference being when you pay taxes. With a Roth you don’t take a tax deduction as you save so you don’t need to pay taxes on the money in the future, maybe ever. Roth accounts were created in the late-90’s and took a while to get traction, so retirement savers haven’t had as much time to accumulate money in these accounts. This is probably a big part of why the old rule of thumb didn’t include them.
But this is changing as retirement researchers (and your humble financial planner) question some of the industry’s core assumptions. For example, researchers at JPMorgan demonstrate how the younger someone is and the lower their tax bracket, the more value they get from Roth accounts. Savers should only think about contributing to a traditional account as they age and make more money (and pay more taxes). The following chart illustrates this.
Managing taxes is completely boring to most people. This is understandable because the tax code is immensely complicated, there are frequent changes, and the language used is, well, anything but exciting. That said, the adage of “it’s not what you make, it’s what you keep”, is important to remember when saving for and living in retirement. To me this means not paying a penny more in tax than you have to.
As we end another wild quarter today, let’s look at an important change that could be an opportunity for some: RMD forgiveness in 2020.
Congress passed the CARES Act relief package during March in response to the coronavirus. Among its many provisions was one allowing folks to skip taking a Required Minimum Distribution (RMD) from their IRA during 2020. I think the idea was not to force folks age 72 and older to withdraw from accounts that were likely losing money. This was also geared toward older savers who are forced to withdraw from their IRA each year even though they may not necessarily need the money to spend. Maybe they have other savings and would prefer to leave their IRAs alone as much as possible.
Under the CARES Act Congress said that if you had already taken an RMD you could pay it back within 60 days. And if you hadn’t yet taken one you could skip it. RMDs are taxed as ordinary income in the year taken, so not being forced to take one means less tax to pay, maybe keeping you in a lower tax bracket, and potentially other positive ramifications.
This was great news except that Congress, in its infinite wisdom, started this as of February 1st, meaning RMDs taken during January wouldn’t qualify and would still be taxable. Congress also left out non-spousal beneficiaries who are required to take RMDs. This seemed unfair at the time, but the thinking was maybe Congress would come back and fix this problem later, as often happens after some time has passed and errors are noticed.
Well, last week the IRS beat them to it. The tax authority released guidance allowing all 2020 RMDs to be paid back by August 31st, regardless of who took them and when. It’s unclear what authority the IRS has to make this change, which seems to rewrite the law and is Congress’s job, but I don’t know if anyone will complain.
So, last week’s IRS update was meant to level the playing field for folks who can, one way or another, do without their RMD this year. If that’s not you, you don’t need to consider this at all.
But if it is you, it’s a good idea to reevaluate your RMD for 2020. Have you already taken one but can afford to pay it back? If you haven’t taken an RMD yet, do you financially need to do so? Avoiding it this year could save thousands in taxes while leaving your retirement savings to hopefully grow a little longer. This is tax management made simple, at least for this year.
Have questions? Ask me. I can help.
Covid-19, social unrest, an urgent national conversation about systemic racism. None of these issues seem to go along with surging stock prices. Even though stocks fell last week, how is it possible for the stock market to rise so fast given all that seems to be going wrong in the world? What are realistic expectations for stocks going forward? Let’s spend a few minutes addressing these questions.
Among all the news lately you might have missed how the government agency that tracks recessions announced that a recession began in late-February. I don’t think this comes as news to anyone, but it’s good to know when these things start and stop. What seemed strange at the time was how the announcement coincided with major stock indexes like the S&P 500 getting back to even for the year. I’m going from memory, but stocks were up on the date of the announcement as well. It just added to the weirdness factor of stocks rising in the face of so many negative headlines.
As we’ve discussed before the stock market isn’t the economy. It can seem like it is because the changing values of major indexes like the Dow and NASDAQ are quoted in the news every business day. Instead, it’s a place (in the most general sense of the word) where investors buy and sell company stock based on expectations about the health of the economy and how public companies will perform over time. I emphasize public because only about 1% of our country’s businesses are publicly held and traded on stock exchanges, according to the National Bureau of Economic Research (the same agency that calls recessions, by the way). Even though the percentage is small, it’s a diverse list of thousands of businesses that employ roughly 1/3rd of the country. So, while these companies are obviously not the real economy all by themselves, their performance in the stock market serves as a good temperature check on how things are going in the business world.
But the stock market is still just a market filled with buyers and sellers (and a lot of computer algorithms, of course) who are normally rational and look past the day’s non-financial headlines. This might sound unfeeling, but if you think about it that’s exactly how it should sound. While markets are prone to bouts of manic depression and irrational exuberance, they are still based on dollars and cents fundamentals and always, eventually, come back to them. When investors have what they think is good information, they put their rational hats on and their confidence shows up as relatively stable, rising prices for stocks. But when investors start losing confidence in their information, well, that’s when the wheels start coming off.
Case in point is our current situation. Stock prices briefly made it back to even year-to-date two weeks ago after a massive run from the lows of mid-March. Investors during this period were feeling a tailwind from Federal Reserve policy, the huge stimulus bill and, at least in May, positive developments in coronavirus numbers. Add in some better-then-expected news about the economy and investors were pricing in a V-shaped recovery, assuming that we’d be back to normal by year’s end. And we were already assumed to be in a recession, which was why making it official was such a nonevent.
But then states like Texas and Arizona started reporting upticks in virus cases as June began. This rekindled fears of a second round of shutdowns later this year, which obviously would be bad for everyone. Investors quickly realized they had gotten ahead of themselves in the recent rally and began taking profits last week. This sent stock prices down by the largest amount since the dark days of March.
These recent weeks are instructive regarding what to expect going forward. As we discussed previously, recovering from the self-induced coma we’ve put ourselves in is likely to look more like a jagged Nike Swoosh than a V shape. Housing, for example, is doing quite well nationally since interest rates are extremely low. This helps homeowners feel wealthier, allowing them to be mobile and spend more money. This in turn helps fuel our consumption-based economy but does little, of course, for someone who doesn’t own a home or have a solid job. Restaurant owners in Texas, for example, have the opportunity of being open but are still experiencing a 45% decline in reservations compared to this time last year, according to the booking website OpenTable. How long can a business survive in conditions like that? There are tons of mixed messages like these coming from all over our economy. This is likely to last awhile and perpetuate uncertainty.
Because of this we, as investors in the stock and bond markets, should expect more short-term market declines as we climb up the Swoosh, so to speak. Hopefully, they won’t be anything close to what we experienced in February and March. Those were historic moves. But couple the uncertainties of our current situation with the historic reality that secondary drops typically follow major market declines, and we’d be silly not to expect a bumpy road ahead.
Have questions? Ask me. I can help.