Some of you may have heard the news: there was a new tax law that passed both houses of Congress, it was signed by the President, and the Supreme Court has not considered it illegal. This trifecta is a rare feat, indeed! Now, we still do not know 100% of what the tax plan entails but what we do know allows us to consider a few strategies for our clients. Here are a few to mull over for 2018:

RMD TO CHARITY TRANSFER

Let’s begin with the definition of required minimum distribution (“RMD”). Your RMD is the amount of money that the IRS requires you to take out of your pre-tax qualified accounts (401k, Roth 401k, 403b, IRA, IRA annuity, 403b, 457, etc.) after you reach age 70-1/2. The RMD to Charity transfer is an older rule that allowed you to gift your RMD directly to a qualified charity and deduct the charitable contribution EVEN if you did not itemize your taxes. This is a special rule that is applicable for RMD to Charity transfers only.

Last year, if you itemized your deductions, you could gift money to your charity of choice and itemize the gifts on the Schedule A of your 1040. This RMD to Charity transfer would not have hurt or helped you because you were already deducting your charitable gifts. In 2018, everyone’s standard deductions have almost doubled and therefore you may not be able to deduct the charity contributions anymore. Instead of making charity donations from your pocket or bank account, it may be beneficial to give to a charity directly from your RMD.  Look at it this way, you would have needed to take the money out anyhow and under this rule, you’ll be able to deduct it off your tax return!

Lastly, because many of our clients have Charles Schwab as the custodian for their accounts, we can set up a check book that is tied to your IRA allowing you to write a check to your favorite charity from your IRA and it will count as a RMD to Charity transfer. This is a very nifty feature!

Let us know if you are interested in hearing more!

ROTH CONVERSIONS

A Roth Conversion is the process where you take money from your IRA and convert it into a Roth IRA. You pay ordinary income taxes on the amount that you convert, but once the money is in a Roth IRA,  the withdrawals will be tax free to you and to your beneficiaries regardless of how much the account grows! Roth IRAs can be very powerful. Though the future tax-free growth is a great benefit, there is an additional strategy that involves using Roth Conversions to your tax advantage.

Use the following numbers as an example: Before you and your spouse, if applicable, draw Social Security (“SS”), and before you start to take RMDs (see above for definition) at 70-1/2, you are in a nice, low tax bracket of 10%. But, once you turn on your SS and your RMD, you are in a high tax bracket of 20%. If, before you turned on your SS and RMD, you converted IRA money to Roth money and brought your taxes to 15% now (remember, conversions are taxable!), that 15% is still lower than 20% when your SS and RMD are turned on. Therefore, in this example, you would be saving 5% on taxes on the amount that you converted.

Now that we understand how a conversion works, what does the new tax plan mean for Roth Conversions? The new tax law allows for more people to benefit from doing a Roth Conversion and it allows for potentially larger Roth Conversions for those who are already doing an annual Roth Conversion. If this type of conversion interests you, make an appointment and we will work together to figure it out!

20% DEDUCTION ON PASS THROUGH BUSINESS INCOME

This one can be very complicating, but let’s start with the 20,000-foot view. If you receive income from pass-through business (e.g. sole proprietorship, partnerships, S corps) you may be able to take 20% of that income as a tax deduction. For example, if your spouse earns $20,000 from part-time at a hospital and you are self-employed and making $15,000, then under this new law, you may be able to take $3,000 as a tax deduction ($15,000 * 20%).

Now, there are many stipulations that determine whether you can take the deduction. For example, the IRS may not allow businesses that are considered “professional businesses” (e.g. accountants, financial advisors, lawyers) to take the deduction. Second, there is an income limit on all other businesses. Third, tax experts are still in the process of trying to figure out the details of this rule.

The key for this rule is to know that it exists and start working with your CPA now so you can plan for next year’s tax return.

Overall, the new tax plan adds new rules and subtracts others. We are not CPAs or tax accountants. It is very important to work with your CPA and/or tax accountant on these strategies. Doing them right can benefit you very much, but doing them wrong can have the reverse affect. Do not take this article as your sole source of what you should do for your tax plan. Not only are we not CPAs or tax accountants, but it would be a mistake to not look at your entire financial picture before enacting these strategies.

Please open your economic textbooks to page forty-seven, class, because it’s time to talk about something you probably haven’t thought of since college: tariffs.

On Thursday, March 1, President Trump announced a new plan to institute a 25% tariff on steel imports and a 10% tariff on aluminum.¹  Like so many things these days, the response was radically different depending on who you talk to.  More on that in a moment.

Traditionally, tariffs are something most of us don’t have to think about, especially as tariff levels in the United States have been low for decades.  But for investors, President Trump’s announcement has the potential be very significant.  Why?  Because of the possibility that it could spark a trade war.

Should a trade war actually happen, it could have a major impact on investors.  To understand why, let’s have a short Q&A session.

What are tariffs and why do they matter?

Since it’s probably been a while since your Economics 101 class, let’s quickly cover a few basics.

To put it simply, a tariff is essentially a tax on imported goods and services.  Tariffs can be levied on almost anything: metals, foodstuffs, products, etc.  Historically, tariffs are most commonly used when a country wants to protect certain industries within its own borders.  For example, the Tariff Act of 1930 was designed to protect farmers by increasing the cost of importing agricultural products.  By making it more expensive to import crops from other countries, people would be forced to buy mainly from American farmers.  This is known as protectionism.

Once upon a time, tariffs in the United States were both high and common.  But after World War II, average tariff rates dropped significantly, and have stayed low ever since.  In fact, since the 1970s, the average tariff rate on imports has been well under 10%.²

So are tariffs good or bad?

Remember how I said the response to President Trump’s announcement was radically different depending on who you talk to?  That’s because a tariff’s effects can vary wildly, too.

Tariffs can bring two major benefits:

1. Because tariffs are a kind of tax, they can bring more revenue to the government.
2. Tariffs, and protectionism in general, can be a major boon to certain industries – including the workers within those industries. In this case, the U.S. steel industry would benefit from a 20% tariff on steel, because it means more people are buying from them instead of their competitors overseas.

You can see why the idea of tariffs can be attractive for many people.

Unfortunately, tariffs can also cause some very negative side effects.  Specifically:

1. Tariffs can make life more difficult for consumers, whether they be individuals, families, or businesses. That’s because higher tariffs often lead to higher prices, which in turn lead to higher expenses.  For example, if companies must pay more for the steel they need, that could significantly eat into their own profits.
2. Higher tariffs can lead to trade wars.

Okay, so what is a trade war, anyway?

We live in a global, interconnected world.  Toss a stone into the water off one shore and the ripples can be seen near another.  In this case, higher tariffs can cause some very large ripples.

When one country raises tariffs on a certain kind of product, other countries that depend on exporting that product won’t take to it kindly.  As a result, those countries might retaliate by increasing tariffs on their imports, thereby harming the first country.  Before you know it, tariffs become weaponized and a trade war breaks out.

Trade wars are risky things, because they can quickly jump from industry to industry.  Let’s take the current situation as an example.

After President Trump announced his plan to raise tariffs on steel and aluminum, the European Union threatened to do the same to U.S. imports – everything from motorcycles to bourbon to bluejeans.³  Other countries like Japan and Canada, which are both major steel producers and important trading partners, have threatened similar measures.  Should all this happen, the currents of international trade will quickly become choked.  That would lead to higher prices on many goods and services, which in turn would lead to lower profits, higher costs of living, and even – potentially – higher unemployment.

Should all those things happen, the markets will surely suffer.  As an investor, you don’t need me to tell you what that means.

So why did President Trump decide to raise tariffs?

For decades, the United States has seen a worsening trade deficit with many countries.  In other words, we pay more for importing their goods than they do for ours.  According to the Wall Street Journal, the U.S. “ran a global goods deficit of $810 billion” in 2017.⁴  One of the president’s most long-standing campaign promises was to address that deficit.  It appears that tariffs, along with renegotiating certain trade agreements, like NAFTA, are his tool of choice.

Geopolitical economics is a loaded topic, and there’s a lot of disagreement out there about causes and effects.  Again, tariffs can unquestionably bring lots of advantages, and there’s no question the United States is on the lower end of a trade imbalance with many countries.

At the same time, there’s also no question that Trump’s announcement has spooked both the markets and the global economy.  The Dow fell more than 400 points on the day of the announcement, and continued to fall the next day.⁵  Many world leaders have already warned about a trade war being a very real possibility.  Even many Congressmen in President Trump’s own party have spoken out against the prospect of higher tariffs.  This isn’t surprising, because the Republican party – or at least a large percentage of it – has traditionally been very much in favor of free trade.

As I’m not an economist, it’s not really my place to decide whether protectionism is good or bad.  It’s worth noting, however, that a trade war did break out the last time the U.S. raised tariff rates this high.

The Tariff Act of 1930, or Smoot-Hawley Tariff Act, raised tariff rates to their second highest level in U.S. history.  These days, economists generally agree that the resulting trade war worsened the Great Depression.  (What no one seems to agree on, though, is by how much.)  On the other hand, the United States is in a very different position in 2018 than it was in 1930.  Back then, the Great Depression had long-since started.  These days, our economy is much stronger.  That makes it hard to predict how hard a trade war will hit.

What happens now? 

There are still so many things we don’t know.  For instance, we don’t know if President Trump will actually go through with his plan.  If he does, we don’t know if the tariffs will apply across the board, or if they’ll only be levied against certain countries.  (This is something many of his advisers are recommending.  If our closest allies are exempted, then the effects of a trade war would likely be minimized.)  And we don’t know what other nations will do in response.

What we do know is that the possibility of a trade war can have a substantial impact on the economy and the markets.

At the moment, we are watchin the situation to determine if and when we should take any action.  Back in February, the markets took a hit due to the threat of inflation and rising interest rates – and then recovered.  The markets dipped slightly in response to President Trump’s announcement and we will continue to monitor things in order to know if it makes sense to early to make any changes to ourportfolio.

This is why our team will keep such a close eye on what’s going on in the world.  Part of our job is to keep you informed of any ripples in the water so that you always stay afloat.  It’s impossible for us to say what’s going to happen next, but we’ll tell you this: We’ll always be here keeping our hands on the tiller.

In the meantime, please contact us if you have questions, or if there’s anything we can do for you!

Sources

¹ “Trump to Impose Steep Aluminum and Steel Tariffs,” The Wall Street Journal, March 1, 2018.  https://www.wsj.com/articles/trump-wont-quickly-announce-new-tariffs-on-aluminum-steel-1519921704

² “Average U.S. tariff rates, 1821-2016,” U.S. International Trade Commission, https://www.usitc.gov/documents/dataweb/ave_table_1891_2016.pdf

³ “U.S. allies around the world steel for Trump tariff tussle,” The Wall Street Journal, March 2, 2018.  https://www.wsj.com/articles/asian-allies-steel-for-trump-tariff-tussle-1519977304

⁴ “Trade Wars Are Good, Trump Tweets,” The Wall Street Journal, March 2, 2018.  https://www.wsj.com/articles/trade-wars-are-good-trump-tweets-1519996161

⁵ “U.S. Stocks Tumble After Trump Announces New Import Tariffs,” The Wall Street Journal, March 1, 2018.  https://www.wsj.com/articles/global-stocks-struggle-after-bad-month-1519868670?tesla=y

Hello volatility, our old friend.

By now, you’ve seen the headlines, full of scary-sounding words like rout and storm, plunge and crash.  Whatever you want to call it, investors have certainly endured a rough time over the past few days.  The Dow, dominating the media’s coverage as usual, dropped more than 600 points on February 2, and almost 1,200 points on February 5.¹  That’s a single-day decline of 4.6%, the largest since 2011.¹  The other major indexes were shaky, too.

It’s been quite some time since we’ve seen volatility like this.  The S&P 500 skyrocketed almost 20% in 2017.²  What was even more amazing last year was how calm and consistent the climb was.  Since the election, any declines have been mere blips on the radar screen.

For investors who have grown accustomed to nothing but clear skies and calm seas, all these headlines might seem rather alarming.  But in our experience, once you look at both why and how something works, it seems a lot less ominous.  So let’s examine the why and the how behind this new spate of volatility.

The Search for a Culprit

Pundits often treat volatility like a crime scene.  “Whodunnit?” they want to know.  This leads to a lot of finger pointing at various causes.

If you put all the suspects in a lineup, they would probably stretch out of the room.  So let’s focus on three of the most likely perpetrators.

The first two are all about our own economy.

“Wait a minute,” you’re probably saying, “I thought our economy was doing well.”  And you’re right, it is.  But here’s a truth too many people ignore: The economy and the markets are not the same thing.

Here’s what we mean.  The economy has been growing slowly and steadily for almost a decade.  Unemployment is currently at 4.1%, the lowest it’s been since the turn of the century.³  The labor market continues to add jobs almost every month.  Best of all, there are signs that wages are finally beginning to grow at a faster pace, up 2.9% compared to this time last year.³  This is all welcome news to workers the entire nation over.

For investors, though, this can create a bit of a dilemma.  It might seem paradoxical, but sometimes good news for the economy isn’t always good for the markets.  In this case, so much of the markets’ growth has been due to rising corporate profits.  But a low unemployment rate means that in many industries, there are more jobs available than there are workers.  That forces corporations to pay more to attract and retain talent.  That, in turn, can cut into those aforementioned profits.

Even more important is what a stronger economy means for interest rates.  Ever since the Great Recession, the Federal Reserve has worked to keep interest rates low.  This helped to stimulate more borrowing and spending, which in turn helped the economy keep chugging along.

Only in the last two years has the Fed begun raising interest rates – and their pace can best be described as glacial.  The reason for this is because the Fed didn’t want to raise rates too fast and interrupt a tenuous economic recovery.  But now, renewed economic strength has many believing that higher rates are here again.

When interest rates go up, the cost of borrowing increases.  Companies and individuals both must pay more to take out loans, which can lead to less spending.  Should this happen, economic growth could begin to stall.   Historically, low growth and high rates tend to lead to a dip in the stock market.

Inflation Leaves Its Fingerprints

A related factor is the possibility of higher inflation.

Time for a little Economics 101.  Inflation, to put it simply, is a “sustained increase in the general level of prices for goods and services.”  Put practically, if it costs $1.50 to buy a candy bar when it previously costed only a dollar, you’ve likely got inflation.

Over the last ten years, inflation has remained very low – for many economists, almost mysteriously so, given how low interest rates have been.  But now, there are signs inflation may be on the rise.

One reason for this is because wages are going up.  This is known as cost-push inflation.  When companies pay more in wages, they often raise prices on their goods and services in order to maintain their profit margin.  As we’ve already covered, a sustained rise in prices is the very definition of inflation.

One of the tools the Fed uses to control inflation is higher interest rates.  Because higher rates reduce borrowing, the supply of money circulating throughout the economy goes down.  This, in turn, can lead to less spending on goods and services, thereby prompting corporations to lower their prices.

In short, if inflation goes up, interest rates will likely go up – and we’ve already discussed what higher interest rates could mean for the markets.

Whew!  Got all that?  Good, because there’s a caveat.

Back in December, Congress passed the largest tax reform in thirty years.  A major part of that reform was a massive tax cut for businesses.  Generally, when businesses pay less in taxes, they don’t raise their prices.  But when they pay more in wages, they often do raise prices.

The question, then, is what will most corporations do with their tax cut?  Will they use a big chunk of it to pay their workers more?  If so, we may well see inflation go up.  On the other hand, if corporations use their windfall on things like expansion and new technology, inflation may well stay steady.

Now, if you squint, you’ll probably see something important buried under all this: The recent volatility isn’t because interest rates have skyrocketed, or because inflation has gone up.

It’s because they might go up.

“So what you’re saying, is that this volatility isn’t about what has happened, but about what could happen?”

Yes, that’s exactly what we’re saying.  Welcome to the markets, where almost everything is based on future expectations rather than present realities.  Which leads us to the final, and perhaps most important culprit:

The Butler Did It

Just kidding.

Volatility Has Returned Partly Because Investors Expected It to Return

For months now, analysts have been wondering how high is up.

“When will stock prices hit the ceiling?” they’ve been asking.  “Aren’t stocks going up too high, and too quickly?  When will a new market correction occur?  Aren’t we overdue?”

You see, volatility is inevitable.  Not just in the markets, but in life.  It’s normal.  Far more normal, in fact, than what we saw last year.  And because so many investors kept wondering when it would return, the moment new concerns arise – of inflation, higher interest rates, how to price in the new tax law, etc. – it’s easy to think, “This is it!  The correction is starting.”

Remember, daily swings in the markets are usually driven by expectation and momentum.  When some investors start to buy, a lot of investors often start to buy.  And the same is true when investors start to sell.

So What Should We Do Now? 

Quick story before we answer that.

Back in 1994, a 6.7-magnitude earthquake struck Los Angeles around 4:30am, knocking out power all over the city.

But not all the lights went out.  For the first time in over a century, people looked up and saw thousands of twinkling objects in the sky…and a great, milky band stretching from horizon to horizon.

Then the 911 calls started.

“What is that?” people asked, worried. “Did the earthquake cause it?”

Of course, you can guess what it was: The Milky Way.  For those who had spent their entire lives in the glow of the city, it was something new, something unexpected, something just a little bit scary.  But in truth, it was there all along.  People just couldn’t see it.

Market volatility is similar, in a way.  The factors that can cause volatility are always with us.  Sometimes they’re just hidden.

So what should we do now?

The answer is, not overreact to something just because it’s been awhile since we’ve seen it. 

It’s quite possible that this is just a brief blip.  As of this writing, the markets have already rebounded slightly.  They may continue to do so, and stock prices could continue to go up throughout the year.  Remember, the economy is strong, corporate profits are high, and taxes are low.  The ingredients are there for continued growth.  It wouldn’t be a surprise.

On the other hand, investors may continue to feel jittery.  Inflation could rise, and with it, interest rates.  This may be the start of a larger pullback or correction.

That also wouldn’t be a surprise.

Currently, we are still in the second longest bull market in history, but nothing lasts forever.  Since we can’t control what corporations will do, or what the Fed will do, or what the markets will do, we’ll do what we’ve always done: focus on what we can control.  We’ll stick to our long-term investment strategy, and not react to market volatility as if a crime has been committed.

In the meantime, please know that our team is here for you if you have any questions or concerns.  We’ll continue monitoring both the markets and the economy.  If changing conditions require changes to our strategy, we’ll let you know immediately.

As always, thank you for the continued trust you place in us.  We appreciate you and your business.  Have a great day!

Sources

¹ “The Stock Market Selloff by the Numbers,” The Wall Street Journal, February 5, 2018.  https://blogs.wsj.com/moneybeat/2018/02/05/the-stock-market-selloff-by-the-numbers/?mod=wsjan

² Ryan Vlastelica, “Stocks end otherwise stellar 2017 on a down note,” Market Watch, December 29, 2017.  https://www.marketwatch.com/story/dow-sp-set-to-power-to-fresh-record-on-2017s-last-trading-day-2017-12-29

³ Patrick Gillespie, “America gets a raise: Wage growth fastest since 2009,” CNN Money, February 2, 2018.  http://money.cnn.com/2018/02/02/news/economy/january-jobs-report-2018/index.html?iid=EL

For centuries, people have studied Shakespeare for his wit and his wisdom.  For the past few months, we’ve been sharing some of that wisdom in a series of articles called:

Shakespeare on Finance

Shakespeare never actually wrote about finance, of course.  But as we’ve seen, many of his most memorable lines contain important financial lessons.  This month, we’re going to end this series with a quote from perhaps the Bard’s greatest play of all: Hamlet.

Quote #6:

“This above all – to thine own self be true.”

Hamlet

On the surface, this might not seem to have anything to do with finances – but it does.  You see, as you work toward your financial goals, you may often be tempted – or even advised – to do or want things that aren’t true to your own goals, values, and character.

For example, it’s not uncommon for people to spend money on flashy purchases they don’t really need or want, like a boat, a sports car, or a bigger house, just for the status it brings, or because their friends and neighbors have done it.

It’s not uncommon for people to take risks with their investments which they’re not really comfortable doing, just to follow the crowd or because some loud TV pundit told them to.

It’s not uncommon for people to give up on the goals they’ve set for themselves because someone else convinced them it would be impossible.

In short, it’s not uncommon for people to wander off the path that leads to their dreams, all because they were trying to make someone else happy instead of themselves.

This may seem so elementary that it goes without saying.  But in all our years as financial advisors, it’s a mistake we’ve seen happen time and time again.  It’s why one of the most important financial lessons of all can be summed up in six monosyllabic words: to thine own self be true. 

To put it simply, you get to decide what your goals are – no one else.  You get to decide what you want to accomplish and what you want to protect.  You get to decide your personal investment style.  You get to decide what you do with your money.  You are in control of your own financial future.

There may be many people in this world that you care about, people who factor into your financial decisions.  But when it comes to setting the destination of your financial journey, the only person who matters is you.

So, whenever you make financial decisions, remember this above all:

To thine own self be true. 

We hope you’ve enjoyed reading these “Shakespeare on Finance” articles as much as we’ve enjoyed sharing them.  So, as we prepare to exit stage right, we’ll leave you with all six quotes listed together:

“Better three hours too soon than a minute too late.”

“Go wisely and slowly.  Those who rush, stumble and fall.”

“How far that little candle throws his beams!”

“Foul-cankering rust the hidden treasure frets, but gold that’s put to use more gold begets.”

“How poor are they that have not patience!  What wound did ever heal but by degrees?”

“This above all – to thine own self be true.”

The Bard once said that “all the world’s a stage.”  We firmly believe that if you apply a little Shakespearean wisdom to your finances, you can make your performance a great one.

Balancing the economy between hyperinflation and recession may sound like dangerous work, but it is the current responsibility of our Federal Reserve. The Federal Reserve (“Fed”) is the central bank of the United States, the national bank, so to speak. The Fed’s job is to keep the U.S.’s economy somewhere between growing too fast and not growing at all. To do this, they increase or decrease the money supply (they print or shred money, literally).

As short-term interest rates continue to increase, it is important to understand the effects of increasing interest rates and to understand a very important definition: the bond curve. This article will dive into the effects of interest rates and how they may even be used to predict a recession.

Suppose you have $1,000 in a Certificate of Deposit (“CD”) with a bank offering 1% interest rate. After one year of holding that CD, $10 of interest would have been earned. However, most of you know that by investing in a 3-year CD instead, you may be able to earn a higher interest rate, for example, 2%. A higher interest rate is usually given to longer-term bonds or CD’s because of two very important reasons: 1) Investors require more profit in exchange for locking in their money for longer periods of time and 2) The future is expected to be better off than the present.

The latter point is why capitalism works, why we have inflation, and why you would take $1,000 today rather than taking $1,000 one year from today. Over time, money tends to grow upwards and, hence, the future is usually expected to be worth more than the present. When this is not the case, then there are more serious worries about the economy. Let me expand.

The 10-Year Treasury Bond is debt that the U.S. sells and that almost anyone can buy. The term length is 10 years and it has an interest rate of 2.7%. The 3-Month Treasury Bill is also a type of debt that the U.S. sells; it’s term length is 3 months and its interest rate is 1.5%. The bond curve is the difference between the 10-Year and the 3-Month Treasury debt, so it is currently 1.2% (2.7% minus 1.5%). See the attached chart.  As the Bond Curve approaches 0%, the future becomes less optimistic than the present. This is dangerous grounds, as the Bond Curve has predicted a recession in the United States nearly every time since the early 1960s.

As you may have heard in the news, the Federal Reserve is increasing the interest rate of the 3-Month Treasury Bill. If you’re looking at the previous paragraph and now wondering why the Fed would increase the 1.5% short-term bond, and thus decreasing the bond curve, see next sentence. Decreasing interest rates can be used as “steam release” during an economic slowdown. Corporations always have the option to either save their money or spend it. Decreasing interest rates during an economic slowdown will decrease the amount of money corporations save (because who wants to save at 0% interest rate?). This leads to an increase in corporate spending and thereby spurring the economy. If short-term interest rates are already near 0%, and an economic slowdown occurred, there would be no “steam release” to use. Furthermore, if inflation becomes too high, increasing short-term interest rates is an important method to steady the economy. Therein lies the choice: letting the economy overheat too much and letting inflation get out of hand, or, letting the economy flounder. This is the dance of the Federal Reserve to keep the economy somewhere in the middle.

However, as evidence from the graph below, we have been headed towards zero bond curve since we left the last recession. Now is the time to realize the music could stop and that the market could leave us standing with no chair to sit on. With the stock market at near all-time highs, now may not be the time to sit down, but you should at least know where your chair is.