Pekin Hardy https://pekinhardy.com Wealth Management Mon, 11 Nov 2019 19:44:22 +0000 en-US hourly 1 https://wordpress.org/?v=5.3.1 https://pekinhardy.com/wp-content/uploads/2015/09/cropped-PSS-Logo-Picture-1-32x32.jpg Pekin Hardy https://pekinhardy.com 32 32 Qualified Retirement Plans: Big Benefits for Small Businesses https://pekinhardy.com/qualified-retirement-plans-big-benefits-for-small-businesses/ Mon, 11 Nov 2019 19:43:50 +0000 https://pekinhardy.com/?p=3973 In this Navigator, we examine the most common types of small business retirement plans and discuss their suitability for various types of businesses. Not participating in some sort of a qualified retirement plan is generally a mistake, in our estimation, as business owners can use retirement plans to cut tax liabilities and improve after-tax investment returns.

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Qualified retirement plans are powerful savings tools that can help small business owners and their employees set aside assets for retirement in a tax-advantaged manner. There are many different types of retirement plans available to small businesses, and determining the most suitable type for any business should depend upon its size, its profitability, its ownership structure, and other factors. In this Navigator, we examine the most common types of small business retirement plans and discuss their suitability for various types of businesses. Not participating in some sort of a qualified retirement plan is generally a mistake, in our estimation, as business owners can use retirement plans to cut tax liabilities and improve after-tax investment returns.


Qualified Retirement Plans: Big Benefits for Small Businesses


Small business owners have a lot on their plates. They must make personnel decisions, marketing decisions, purchasing decisions, and the list goes on. One very important decision that may not get the attention it deserves is the type of retirement plan(s) to implement. Employer-sponsored qualified (i.e., tax-advantaged) retirement plans are highly effective savings tools, and they also play a key role in employee benefits packages. Selecting a suitable retirement plan structure is a decision that should not be taken lightly by business owners, as it could have far-reaching consequences for both owners and employees.

Before delving into specific plan types and structures, it is worth taking a moment to think about why a small business owner would want to offer his or her employees access to a qualified retirement plan. Businesses are not required to provide such benefits to their employees, and retirement plans are not without costs. However, from the perspective of the business owner, the benefits of offering a retirement plan usually outweigh the associated costs.

  • Research clearly shows that offering a retirement plan improves employee recruitment and retention.1
  • Offering retirement plan benefits allows business owners to accumulate sizable tax-advantaged savings for their own retirements.
  • Retirement plan expenses help to minimize business income taxes.

For many businesses, establishing and maintaining a qualified retirement plan is truly a win-win for both owners and employees.

With this strong case for offering retirement plans as a backdrop, let’s now examine some of the specific types of retirement plans that small businesses may choose to implement.

Small businesses can choose from several different types of qualified retirement plans. The most appropriate plan type for a specific business depends on several factors, but the size of the business is a key determinant in selecting an appropriate retirement plan type. Some plan types are more appropriate for smaller businesses or sole proprietorships, while others are more versatile and can be implemented in businesses of widely varying sizes. The table below shows the appropriateness of some popular retirement plan types for businesses of varying size.


 SEP IRA


 Appropriate for: sole proprietorships, businesses with fewer than 100 employees

A Simplified Employee Pension Individual Retirement Arrangement (“SEP IRA”) is a defined-contribution pension plan designed to provide sole proprietors and small businesses with a low-cost, efficient retirement savings vehicle. SEP IRAs are easy to administer, and they allow for tax-deferred growth before money is withdrawn. Employers and sole proprietors may contribute up to 20% of taxable income to a SEP IRA each year, and the contribution limit rises to 25% if the business is incorporated. Contributions are capped at $56,000 for 2019. SEP IRAs do not require an annual IRS Form 5500 filing, which can help to keep plan administration costs down. 2

Both employers and employees can make retirement contributions to SEP IRA accounts. Contributions made by the employer on an employee’s behalf must be the same percentage for each employee annually. These contributions are treated as a business expense and are not mandatory every year. However, employers must decide each year whether or not to fund their SEP IRA accounts, and, if they make contributions for themselves, they must also make contributions for all eligible employees.

Any employee who has worked for the same employer in at least three of the past five years is generally allowed to participate in a SEP IRA, provided that he or she is at least 21 years of age and earns at least $600 annually. SEP IRAs carry the same rules as traditional IRAs when it comes to employee contributions: employees can contribute up to $6,000 each year or $7,000 if they are age 50 or older for tax year 2019. Sole proprietors are subject to the (higher) employer limits rather than the employee limits.

Similar to traditional IRAs and 401(k) plans, any SEP IRA withdrawals that occur before age 59½ are subject to ordinary income tax as well as a 10% penalty. Withdrawals become mandatory after age 70½. All withdrawals from a SEP IRA are taxed at ordinary income tax rates at the Federal level, regardless of the age at which distribution happens.
SEP IRA assets, like other IRA assets (Roth, Traditional, etc.), can typically be invested in a vast array of investments, limited only by restrictions imposed on the part of the custodian of the plan. In most cases, SEP IRA assets can be invested in stocks, bonds, mutual funds, and ETFs at the account owner’s discretion.


 SIMPLE IRA


Appropriate for: businesses with fewer than 100 employees

A Savings Incentive Match Plan for Employees Individual Retirement Arrangement (“SIMPLE IRA”) is an alternative to 401(k) plans for businesses with 100 or fewer employees. Like SEP IRAs, SIMPLE IRAs are defined-contribution plans, and employers can either match employee contributions or simply contribute 2% of employee salaries up to the statutory contribution limits. Employers who match employee contributions may match up to the lesser of 3% of each employee’s salary or $13,000 for tax year 2019 ($16,000 if the employee is 50 years old or more). Taxable corporate income is reduced by the amount of the contributions, while employees and the business owner receive extra tax-deferred compensation via contributions to their retirement accounts. Like SEP IRAs, SIMPLE IRAs do not require an IRS Form 5500 filing.

There are no age limits on participation in a SIMPLE IRA plan. However, withdrawals made before age 59½ will incur a steep 25% penalty if the withdrawal occurs within the first two years of joining the plan and a 10% penalty thereafter, unless a qualifying exemption applies. SIMPLE IRA assets may not be rolled out of a plan (to another employer plan or another IRA) within the first two years of a plan’s existence.

Assets in a SIMPLE IRA, like those in a SEP IRA, can be invested in any securities to which the plan’s custodian has access, including stocks, bonds, mutual funds, and ETFs.

 


 401(K) 


Appropriate for: businesses of all sizes

Named for the subsection of the Internal Revenue Code in which they are defined, 401(k) plans are defined-contribution pension accounts that allow employees and employers to set aside tax-advantaged funds for retirement. 401(k) plans are extremely common in the United States, as approximately 79% of Americans work for an employer that sponsors a 401(k)-style retirement plan.3 401(k) plans may be appropriate for businesses of all sizes, from sole proprietorships to very large enterprises with thousands of employees, as plans can be tailored to fit the specific needs of the sponsoring business.

While 401(k) plans are highly customizable, nearly all 401(k) plans share certain characteristics. 401(k) plans allow employees to contribute pre-tax income into a retirement account which can be invested on a tax-deferred basis in a range of pre-determined investment options.4 Taxes are eventually paid at ordinary income rates when distributions take place during retirement. Employers may also contribute to employee accounts, and such contributions reduce taxable income at the corporate level. In a given tax year, an employee may contribute up to $19,000 to a 401(k) plan. Employees over the age of 50 may contribute an additional $6,000 each year as a so-called “catch-up” contribution. Combined employee and employer contributions to an individual’s 401(k) account cannot exceed $56,000 per year ($62,000 for those over 50).

The IRS wants to ensure that 401(k) plans are benefiting all employees, not just the highest-paid employees or owners of companies. For this reason, the IRS requires that 401(k) plans pass annual discrimination testing. These tests seek to determine if key employees/firm owners are benefiting significantly more from the plan than other employees. Plans that do not pass these tests each year can be penalized and may be forced to give contributions back to key employees/owners who must then pay taxes on the returned contributions.

One of the best ways to avoid running afoul of IRS discrimination rules is to implement a Safe Harbor provision, in which employers commit to making mandatory contributions to employee accounts. Employers may choose from three types of mandatory contributions:

  1. Non-elective Safe Harbor: The employer contributes 3% of each eligible employee’s salary to the plan, regardless of whether or not the employee contributes to the plan.
  2. Basic Safe Harbor Match: The employer matches 100% of the employee’s contribution up to 3%, then matches 50% of the next 2%. For employees to receive the employer match, they must contribute to the plan.
  3. Enhanced Safe Harbor Match: The employer matches 100% of the employee’s contribution up to 4%. Employees must contribute to the plan in order to receive the match.

Employers who include Safe Harbor provisions in their 401(k) plans can generally avoid the IRS’s discrimination testing. Such provisions are also popular with employees, as they amount to an effective pay raise, making Safe Harbor 401(k) plans a win-win for businesses.

A 401(k) plan sponsor may also choose to implement a Profit Sharing provision, which allows an employer to make discretionary contributions to employee accounts above and beyond any mandatory Safe Harbor contributions. While Profit Sharing contributions are not capped per se, total annual contributions, including both employee deferrals and any employer contributions, may not exceed $56,000 in 2019 (or $62,000 if the employee is age 50 or above).

 


 OTHER 401(K) VARIATIONS


Businesses can choose from several 401(k) variations, including Solo 401(k) plans and SIMPLE 401(k) plans.

— SOLO 401(K) —

Appropriate for: sole proprietorships

Solo 401(k) plans are 401(k) plans that cover businesses without non-owner employees. Because they only cover owners and their spouses, Solo 401(k) plans are not subject to IRS discrimination testing. However, a Form 5500 filing is still typically required.

Contribution limits for Solo 401(k) plans are the same as for Traditional 401(k) plans ($19,000 or $25,000 for employee deferrals and $56,000 or $62,000 for total contributions). However, because the employer and employee are one and the same, a special calculation determines how much an employer may contribute. Employer contributions are limited to 25% of net income, which is defined as gross income less half of self-employment taxes and all employee deferrals. An example may help to illustrate this calculation:

John is a 45-year-old sole proprietor and earns $150,000 in gross income from his business. He elects to defer $19,000 of his income to his Solo 401(k). His self-employment taxes amount to $20,829.60 (15.3% of the first $132,900 of income plus 2.9% of income above $132,900). Therefore, John can make an employer contribution of $30,146.30 to his Solo 401(k).

25% * ($150,000 – $19,000 – 0.5 * $20,829.60) = $30,146.30

— SIMPLE 401(K) —

Appropriate for: businesses with fewer than 100 employees

Like SIMPLE IRAs, SIMPLE 401(k) plans are useful for small businesses with 100 or fewer employees. Like Traditional 401(k) plans, they allow for employee deferrals (up to $13,000 in 2019 or $16,000 if the employee is age 50 or older). However, unlike other 401(k) plans, SIMPLE 401(k) plans require employers to contribute to each eligible employee’s account according to one of the two following methodologies.

1. A matching contribution up to 3% of each participating employee’s pay

2. A non-elective contribution of 2% of each eligible employee’s pay, regardless of participation.
No employer contributions are required beyond those listed above, and employees are fully vested at any contribution level. SIMPLE 401(k) plans are not subject to IRS discrimination testing, but a Form 5500 filing is required.

SIMPLE 401(k) plans are very similar to SIMPLE IRA plans, with one primary exception: SIMPLE IRAs do not allow participants to take loans from their accounts, while SIMPLE 401(k) plans do. A business owner who wants the option of taking loans from his or her account or who wants to offer such an option to employees without having to deal with IRS discrimination testing may find it attractive to implement a SIMPLE 401(k) plan.


 CASH BALANCE PLAN


Appropriate for: businesses of all sizes with highly predictable cash flows

A cash balance plan is a defined benefit plan that allows individuals in predictably profitable businesses to set aside substantial amounts of retirement money each year on a pre-tax basis. Such amounts are typically made in addition to contributions made to a 401(k) plan and/or a profit-sharing plan. Cash balance plans differ from other defined benefit plans (i.e., traditional pension plans) in that they define promised benefits in terms of an account balance, rather than a monthly or annual payment. Unlike defined contribution plans, investment risks related to a cash balance plan are borne by the employer, not the employee. Given this structure, one might think of a cash balance plan as a sort of “hybrid” retirement plan that incorporates characteristics of both defined benefit plans as well as defined contribution plans.

Cash balance plans offer significant benefits to participants, chief among them being the ability to make large tax-deductible contributions each year, well in excess of those allowed by traditional 401(k)/profit sharing plans ($56,000 or $62,000). Technically, cash balance plans do not have an annual limitation on contributions. Instead, cash balance plans have a maximum lump sum amount that can accumulate for any one participant, meaning that the annual contribution amount allowed is a function of the interest credit rate and the participant’s age.5 Younger participants have lower annual contributions because they have more years to accumulate the maximum lump sum amount.

While cash balance plans can be implemented by businesses of all sizes and are typically highly beneficial for participants, they are also relatively complex and typically require professional assistance in plan design and maintenance. For this reason, cash balance plans may only be appropriate for a small subset of businesses.


 CLOSING THOUGHTS


Our discussion of small business retirement plans has not been exhaustive, as there are countless variations and iterations of the various plan types outlined above. Many plan types can be customized to fit the specific needs of the sponsoring business. The most important takeaway here is that all small businesses can find a retirement plan that works for them, and business owners should do whatever they can to participate to the maximum extent possible in that retirement plan.

If you are considering implementing a qualified retirement plan for your small business or you are considering making changes to your existing retirement plan, please reach out to us to discuss potential solutions.


This article is prepared by Pekin Hardy Strauss, Inc. (“Pekin Hardy”, dba Pekin Hardy Strauss Wealth Management) for informational purposes only. The information and data in this article does not constitute legal, tax, accounting, investment or other professional advice. The views expressed are those of the author(s) as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions.

  1. https://business.betterment.com/wp-content/uploads/2018/08/2018-08-22-B4B-Customer-Survey-Report.pdf
  2. IRS Form 5500 is an annual report filed with U.S. Department of Labor (DOL) that contains information about a qualified retirement plan’s financial condition. Filing of a Form 5500 typically requires the involvement of a tax professional.
  3. U.S. Census Bureau.
  4. Some 401(k) plans allow participants to make after-tax Roth contributions as well.
  5. A plan’s interest credit rate is a guaranteed rate of return as specified by the plan document. It is typically tied to long-term Treasury yields or is stated as a low, fixed rate (e.g., 3% per annum).

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Investing in Uncertain Times https://pekinhardy.com/investing-in-uncertain-times/ Fri, 25 Oct 2019 16:17:29 +0000 https://pekinhardy.com/?p=3940 Slowly but surely, the world has been moving from compromise and coordination to name-calling and tribalism. We read news of impeachment inquiries, trade wars, mass demonstrations, accusations of treason, worsening geopolitical tensions, conspiracy theories, fake news, and Twitter curses, sometimes all in the same day. The current period will likely be studied closely by historians trying to make sense of the many seemingly irreconcilable conflicts that have surfaced.

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Photo by JackF

“Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.

W.B. Yeats, “The Second Coming”

Slowly but surely, the world has been moving from compromise and coordination to name-calling and tribalism. We read news of impeachment inquiries, trade wars, mass demonstrations, accusations of treason, worsening geopolitical tensions, conspiracy theories, fake news, and Twitter curses, sometimes all in the same day. The current period will likely be studied closely by historians trying to make sense of the many seemingly irreconcilable conflicts that have surfaced.

Rising areas of contention include, but are not limited to: the United States vs. China, the rich vs. the poor, the old vs. the young, capitalists vs. socialists, Democrats vs. Republicans, and globalists vs. nationalists. Many of these conflicts seem irreconcilable, which means that a risk exists that some conflicts could be fought until won or lost rather than negotiated through compromise. The ongoing news about these conflicts creates uncertainty and stress for all concerned citizens.

As investors, we do not yet know how these conflicts will get resolved. Just as it would have been impossible to predict the drone attack that took place in September against Saudi Arabia, crippling approximately 50% of its oil processing capacity, it would be folly for us to make concrete predictions about political outcomes. Nevertheless, we have no choice but to express an opinion about probable outcomes through the investment decisions we make on behalf of our clients.

In this regard, we thought it would be useful to focus on a few areas of particular friction and discuss their likely economic and financial implications.

Global Geopolitical Uncertainty
Two phenomena have driven the increased friction between the United States and China. First, as China’s economic and military strength has grown, China is increasingly able to challenge the global hegemony of the United States from economic, military, cultural, and monetary standpoints. Second, ever since China joined the World Trade Organization in 2002, U.S. manufacturing job losses accelerated as U.S. companies built new production capacity in China while closing down domestic manufacturing facilities, which has exacerbated rising economic inequality within the United States.

While President Trump and Chairman Xi negotiate the terms of the U.S./China bilateral relationship, the uncertainty is unsettling for financial markets. President Trump often tries to buoy the stock market with hopeful tweets about trade discussions, except for when he scares the stock market with defiant tweets that stoke geopolitical tensions. As time passes, it grows more likely that the United States and China could enter a new cold war. In a worst-case scenario, we would expect to see a bifurcation of supply chains, payment systems, technology infrastructure, financial markets, and even the Internet. In a best-case scenario, we would expect a bilateral agreement between the United States and China that allows for limited trade and places additional restrictions on currency manipulation.

With regard to the Middle East, the United States is trying to withdraw from its role as a regional peacekeeper. As we write this letter, President Trump has announced his intent to withdraw from Syria. The drone attack on Saudi Arabia’s processing facilities probably took advantage of the Trump administration’s communicated lack of appetite for engaging in new regional conflicts in the Middle East. With less interest and ability to project power in the region, the U.S. will allow other countries like Russia, China, and Iran to fill the void.

The international monetary system, too, is in the middle of a transition as a unipolar monetary system centered around the U.S. dollar becomes increasingly multipolar. Since the Financial Crisis, perhaps in anticipation of current geopolitical shifts, foreign central banks have been turning away from the U.S. dollar as a hard currency reserve and turning towards gold. The United States has attempted to combat these efforts through economic sanctions, but sanctions are causing many countries to become even more eager to reduce their reliance on a U.S. dollar-centric monetary system.

With the United States withdrawing or reducing its military presence in the Middle East, the role of the U.S. dollar as the currency of choice in oil markets will inevitably diminish. China, which has become the largest importer of Middle East oil, should find it increasingly easier to buy oil without using U.S. dollars to do so. For example, in September, Petroleum Economist reported the terms of a strategic partnership between China and Iran whereby China would provide Iran with $400 billion of direct investment and 5,000 Chinese security personnel in return for Iran’s agreement to accept non-dollar currencies for its oil, including the Chinese renminbi. This development, and others like it, will inevitably reduce long-term global demand for U.S. dollars.

As the world shifts from a unipolar one with the United States as the world’s policeman and reserve currency issuer to a multipolar one, it should inevitably mean higher trade barriers, less globalization, less foreign hoarding of U.S. dollars, more support for gold as an international reserve, and fewer military commitments overseas for the United States.

Domestic Political Uncertainty
Over the past 30 years, with increased globalization, low inflation, and declining interest rates, U.S. investors have benefited greatly from increasing corporate profit margins and strong financial returns. At the same time, while wage gains have been robust for the upper 10% of the income distribution and especially for the upper 1% and above, wages for the bottom 90% of the income distribution have remained stagnant. As a result, income and wealth inequality has reached extreme levels not seen since the early 1930s, resulting in social discontent, class conflict, and the rise of populist politicians like Donald Trump on the Republican side and Bernie Sanders, Elizabeth Warren, and Andrew Yang on the Democrat side.

When considering the theme of economic inequality, we are reminded of historian Will Durant’s warning that an “unstable equilibrium generates a critical situation, which history has diversely met by legislation redistributing wealth or by revolution distributing poverty.” Current prescriptions that propose to address economic inequality vary. Some propose devaluing the dollar (e.g., Warren, Trump), thereby reducing the real value of debt obligations. Others propose wiping away debts, such as college loans (e.g., Warren, Sanders). Meanwhile, several want to use tax and fiscal policy to redistribute wealth explicitly (e.g., Yang, Sanders, Warren).

Regardless of the outcome of the 2020 election, whoever becomes president will likely face a starkly divided nation, enjoying wild popularity among one-half the electorate while being despised by the other half.

For investors, however, it may be the similarities between President Trump’s plans and various Democrat plans that are worth noting. President Trump has made it abundantly clear that he has no intention to lower the Federal deficit. If anything, he would be eager to sign a bill that increases spending to invest in infrastructure or further reduce tax rates. While Democratic candidates are calling for increased taxes, the taxes planned would hardly pay for proposed new spending. The top presidential candidates seem to all agree that keeping the Federal deficit under control is no longer a policy priority.

During the three consecutive years between 2016 and 2018, the budget deficit has expanded without a recession for the first time in U.S. history and is currently running at approximately 4% of GDP (see chart below). Based on current Congressional Budget Office projections, it is difficult to see anything that would get in the way of growing deficits during the next several decades, even without any policy changes. The policy proposals of President Trump and most Democratic presidential candidates would worsen an already poor budget outlook.

An increasing deficit is concerning enough, but the situation is made worse by the fact that the U.S. Treasury is starting to have increasing difficulties in financing these deficits. Since 2014, U.S. private investors, especially U.S. primary dealers such as JPMorgan Chase, have absorbed most of the additional supply of U.S. Treasuries (see chart below). However, these primary dealers have little room to expand their balance sheet further to buy U.S. Treasuries, which is why the Federal Reserve will have to become an increasingly significant source of government funding.

Indeed, in recent weeks, the Federal Reserve has begun to increase the size of its balance sheet again by purchasing U.S. Treasury bills to ensure that the Federal government remains funded (see chart below). While denying any kinship to the quantitative easing measures that took place earlier this decade, the Federal Reserve has resumed these purchases while the only visible difference is that its purchases are restricted to short-term Treasuries.

We expect that the Federal Reserve will continue to “inject liquidity” and buy U.S. Treasury bonds as necessary with that liquidity, with no end in sight. Our confidence level is supported by the large supply of Treasury bonds that already has become too large for private investors to absorb and  should only increase in the future.

Investment Implications
The ongoing, centrifugal transition towards a multipolar geopolitical environment and a more populist but divided political environment should have important repercussions on the economy and financial markets. For the United States, a less globalized economy and increasing fiscal deficits monetized by the Federal Reserve are likely to result in higher wages, lower corporate profit margins due to increased labor costs, accelerating cost-push inflation, reduced capital inflows, a lower exchange rate for the U.S. dollar, and a renewed policy focus on domestic manufacturing production.

Inflation’s acceleration has already begun, albeit quietly, due to a combination of increased tariffs, reduced immigration, and minimum wage increases, despite the dollar remaining strong up until this point. The consumer price index (CPI) is currently at a ten-year high. Further acceleration of inflation, while harmful to consumers and especially so to retirees, would make it easier for the U.S. government to reduce the real debt burdens of the Federal government, U.S. corporations, and U.S. households alike.

With a weakening dollar, we would expect foreign stock markets, commodities, and gold to outperform. On the other hand, those companies which have benefited greatly from globalization trends, such as Apple and Boeing, will probably have a difficult time maintaining current profit margins. Stocks that are expensive and trade at elevated P/E ratios should also have a difficult time performing well, as P/E ratios tend to contract when inflation expectations increase. We are still buying selected U.S. stocks for clients, but they are generally not the stocks of companies that have benefited so much from the globalization trend of the past 30 years, and they are generally stocks that already have low P/E ratios.

Despite inflation accelerating, we would expect interest rates to remain low, thanks to U.S. Treasury purchases by the Federal Reserve that would cap interest rates and provide funding for increasing budget deficits. This has happened before, in the years following World War II, when the United States also had a large debt load relative to GDP  (see chart below). Because inflation could very well remain at a level above that of long-term interest rates, long-term bonds remain unattractive investments.

In periods of history where it sometimes feels like everything might be falling apart, such as the one we are all currently living through, trust comes at a premium. Our primary goal is to act as a trusted steward for our clients in managing their assets, during good times and especially during challenging times. We thank you once again for your ongoing trust.

Please do not hesitate to reach out to us with any questions.

Sincerely,

Pekin Hardy Strauss Wealth Management

This commentary is prepared by Pekin Hardy Strauss, Inc. (dba Pekin Hardy Strauss Wealth Management, “Pekin Hardy”) for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any security. The information contained herein is neither investment advice nor a legal opinion. The views expressed are those of the authors as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions. Although information has been obtained from and is based upon sources Pekin Hardy believes to be reliable, we do not guarantee its accuracy. There are no assurances that any predicted results will actually occur. Past performance is no guarantee of future results. The Consumer Price Index (CPI) is an unmanaged index representing the rate of the inflation of U.S. consumer prices as determined by the U.S. Department of Labor Statistics.

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FSA or HSA: Choosing a Medical Savings Account https://pekinhardy.com/fsa-or-hsa-choosing-a-medical-savings-account/ Tue, 01 Oct 2019 17:46:19 +0000 https://pekinhardy.com/?p=2077 Flexible spending accounts (FSAs) and health savings accounts (HSAs) are both tax-advantaged accounts that allow you to pay for qualified medical expenses using pretax dollars. During open enrollment season for employment benefits,you may have the opportunity to choose between an FSA and an HSA. Understanding the advantages and disadvantages of each type of account is essential when it comes to making the right decision for you and your family.

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Flexible spending accounts (FSAs) and health savings accounts (HSAs) are both tax-advantaged accounts that allow you to pay for qualified medical expenses using pretax dollars. During open enrollment season for employment benefits,you may have the opportunity to choose between an FSA and an HSA. Understanding the advantages and disadvantages of each type of account is essential when it comes to making the right decision for you and your family.


FSA or HSA: Choosing a Medical Savings Account


Open enrollment season for health care benefits is coming for many workplaces, and you may soon find yourself trying to determine which selection of benefits is best for you and your family. You may need to choose between a flexible spending account (FSA) and a health savings account (HSA), both of which are tax-advantaged accounts that allow you to cover qualified medical expenses with pretax dollars. Both types of accounts can provide significant advantages, but it can be difficult to determine which is right for you. This Navigator discusses the difference between the two types of accounts and important considerations in choosing between them.


Flexible Spending Accounts


FSAs are the most common savings vehicles offered as part of employee benefit packages. FSAs have no eligibility requirements, but you can only participate in an FSA if your employer offers it as an option. With an FSA, you can set aside up to $2,750 in 2020 (projected) from your income to pay for qualified medical expenses.1  Contributions to FSAs are made from pre-tax income, and you do not pay taxes on FSA withdrawals if they are used for qualified medical expenses.

You choose how much to contribute to the account for the entire year during open enrollment and can only change your contribution level in the case of marriage, divorce, or other major life events. You can withdraw money immediately, even before there is any money in the account, provided you don’t exceed the amount you have chosen to contribute in a year. However, any unused funds remaining at the end of the year are generally forfeited, though some employers will offer a short grace period or small rollover for unused funds. FSAs work well for recurring expenses like eyeglasses, contact lenses, or prescriptions, but you run the risk of needing additional funds for unexpected medical treatment and not having the necessary amount in your FSA. In most cases, you will also leave money in your FSA if you change employers mid-year and you have not spent your entire year-to-date amount.


Health Savings Accounts


HSAs allow more flexibility both in terms of contribution amounts and when you make qualified medical expenditures. You are eligible for an HSA if you have a high-deductible health plan, which is defined as a plan with a deductible of at least $1,400 for an individual or $2,800 for a family in 2020. In order to qualify for an HSA, the high-deductible plan must be your only health insurance and you cannot be eligible for Medicare. Unlike with an FSA, you can use an HSA if you are self-employed or using an Affordable Care Act plan, as the accounts are not dependent on your employer.

Through an HSA, you can save up to $3,550 annually for an individual or $7,100 for a family in 2020, and you can contribute any amount up to the maximum at any time. Many employers also contribute to employee HSA plans, although the amount can vary. Unlike in an FSA, money in an HSA rolls over indefinitely and always belongs to you, regardless of employment status; you can even use it to cover health care expenses after you retire. Additionally, money in an HSA account is invested, so it can grow over time.

Using an HSA can provide significant tax benefits: contributions to HSAs come from pretax income, earnings on the HSA account are not taxed, and you will not pay taxes on withdrawals if they are used for qualified medical expenses. If you withdraw money from an HSA for another purpose before age 65, you would have to pay taxes plus a 20% penalty, but after age 65, you would only pay taxes.

Some people use HSAs as another retirement account: they contribute to the HSA but continue to pay for their medical expenses out-of-pocket, essentially building a fund for medical expenses in retirement. If you choose not to pay for medical expenses through your HSA at the time they are incurred, you can actually withdraw money to cover those expenses years later. As long as you keep the receipts, you could withdraw money in 2019 to offset an unclaimed medical expense in 2016, provided your HSA was open at the time of the expense.


Which is Right for You?


Both FSAs and HSAs have significant benefits for users. In general, you should opt for the HSA if you qualify because it offers a higher limit and allows you to carry your contributions from year to year. However, an HSA might not be right for you if any of the following is true:

  • You are unable to take on the extra expenses that come with a high-deductible plan.  While you will likely have a lower premium with a high- deductible plan, copayments, coinsurance, and out-of-pocket expenses will likely all be significantly higher than under other insurance plans. If you are uncomfortable with or unable to take on higher exposure to healthcare costs, the HSA is not the right option for you.
  • You do not have room in your budget for additional savings into an HSA.  HSAs only provide a benefit if you are able to save into the account to offset the higher out-of-pocket costs of the high-deductible plan. If you choose a high- deductible plan and do not take advantage of the savings opportunity, you will be considerably worse off than you would in a more standard insurance plan.
  • You are able to accurately predict your annual medical expenditures in advance.  If you can reliably plan for medical expenses in a given year, an FSA may be a better option for you.

In most cases, you cannot have both an FSA and an HSA, so it is important to make a well-researched choice of savings vehicle. Both FSAs and HSAs offer significant benefits when used correctly, and both should be considered during your open enrollment elections.


1 Medical expenses are defined as the costs of diagnosis, cure, mitigation, treatment, or prevention of disease. The IRS has complete guidance on what constitutes a qualified medical expense.

This Navigator was originally published in November 2018. It has been updated to reflect new contribution limits for 2020.

This article is prepared by Pekin Hardy Strauss Wealth Management (“Pekin Hardy”) for informational purposes only and is not intended as an offer or solicitation for business.  The  information  and  data  in  this  article  does not constitute legal, tax, accounting, investment or other professional advice. The views expressed are those of the author(s) as of the date of publication of this report, and are subject to change at any time due to changes in market or  economic  conditions. Pekin  Hardy  cannot  assure  that the strategies discussed herein will outperform any other investment strategy in the future, there are no assurances that any predicted results will actually occur.

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Pekin Hardy Strauss Recognized as a 2019 Best For The World Nominee https://pekinhardy.com/pekin-hardy-strauss-recognized-as-a-2019-best-for-the-world-nominee/ Thu, 05 Sep 2019 14:31:46 +0000 https://pekinhardy.com/?p=3771 CHICAGO, Illinois: Pekin Hardy Strauss Wealth Management, a Chicago-based independent investment adviser, has been recognized by B Lab as a 2019 Best For The World Honoree in the categories of Changemaker and Customers. Pekin Hardy Strauss ranked in the top 10 percent of all B Corps for its positive impact on its customers and its […]

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CHICAGO, Illinois: Pekin Hardy Strauss Wealth Management, a Chicago-based independent investment adviser, has been recognized by B Lab as a 2019 Best For The World Honoree in the categories of Changemaker and Customers. Pekin Hardy Strauss ranked in the top 10 percent of all B Corps for its positive impact on its customers and its significant improvement in its overall impact on its workers, customers, community, the environment, and governance.

Best For The World recognition is administered by B Lab, the global nonprofit that certifies and supports Certified B Corporations, which are for-profit companies dedicated to using business as a force for good. Today there are 3,000 Certified B Corporations across 64 countries and 150 industries.

Adam Strauss, Co-CEO of Pekin Hardy Strauss, said the firm is proud to be included on B Lab’s Best For The World list.

“Pekin Hardy Strauss is proud to be a part of the global B Corp™ community, and being designated a Best For The World honoree is a reflection of our commitment to our clients, employees, and community,” he said.

B Corps meet the highest standards of verified social and environmental performance, public transparency, and legal accountability to balance profit and purpose. B Corp Certification doesn’t just evaluate a product or service, it assesses the overall positive impact of the company that stands behind it—like Pekin Hardy Strauss. Using the B Impact Assessment, B Lab evaluates how a company’s operations and business model impact its workers, community, environment, and customers. To achieve the B Corp Certification, a company must achieve a score of at least 80 out of 200 points on the assessment.

“We’re incredibly proud of this year’s Best For The World honorees,” says Anthea Kelsick, Chief Marketing Officer of B Lab. “These inspiring companies represent the kinds of business models and impact-driven business strategies that are building a new economy—one that is inclusive, regenerative, and delivers value to all stakeholders, not just shareholders.”

1,000 B Corps from 44 countries were named to the 2019 Best For The World lists, including Patagonia, Beautycounter, Dr. Bronner’s, TOMS, Seventh Generation, and Greyston Bakery. The 2019 Best For The World honorees are determined based on the verified B Impact Assessments of Certified B Corporations. The full list is available at https://bcorporation.net/.

About B Lab and the Selection Process

The 2019 Best For The World Lists are selected based on verified responses to the B Impact Assessment, a platform that measures a company’s impact on its workers, community, customers, and environment. Prospective B Corps complete the Impact Assessment as a part of the initial B Corp Certification process, and then must update the assessment every three years to ensure they still qualify. Best For The World honorees scored in the top 10th percentile of all Certified B Corporations in the respective impact area on the B Impact Assessment. Of the 3000 B Corps, 1000 were named to the 2019 Best For the World.

Pekin Hardy Strauss is not affiliated with B Lab and the firm has not made any payment for participation in this survey.  Honors of this kind are only one of many factors relevant in determining whether to retain an investment adviser. Please contact Financial Advisor for more information on the methodology of the survey.

B Lab is a nonprofit that serves a global movement of people using business as a force for good. B Lab’s initiatives include B Corp Certification, administration of the B Impact Management programs and software, and advocacy for governance structures like the benefit corporation. B Lab’s vision is of an inclusive and sustainable economy that creates a shared prosperity for all. To date, there are 3,000 Certified B Corps in over 150 industries and 64 countries, and over 50,000 companies use the B Impact Assessment. For more information, visit https://bcorporation.net/

About Pekin Hardy Strauss Wealth Management

Founded in 1990, Pekin Hardy Strauss, Inc. (dba Pekin Hardy Strauss Wealth Management) is a leading independent investment adviser that offers wealth management services and serves as the adviser to a socially responsible value-oriented mutual fund. The firm provides its high-net-worth clients with thoughtful financial advice, comprehensive financial plans and custom investment portfolios. Pekin Hardy Strauss Wealth Management strives to deliver positive risk-adjusted returns by pursuing a disciplined value investing approach that minimizes investment risk with investors’ capital.

The employee-owned, Chicago-based firm is committed to maintaining the highest standards of ethics and objectivity. Pekin Hardy Strauss has been a Certified B Corporation® since 2015, when it became the first investment advisor in Chicago to be certified. Learn more at pekinhardy.com.

B Lab Contact: Hannah Munger; Manager, PR & Communications; hmunger@bcorporation.net; +1 212-608-4150

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Which Is Correct — the Stock Market or the Bond Market? https://pekinhardy.com/which-is-correct-the-stock-market-or-the-bond-market/ Thu, 25 Jul 2019 14:28:19 +0000 https://pekinhardy.com/?p=3766 As the S&P 500 Index reaches all-time highs with an extraordinarily high valuation by most measures, how can the 10-year Treasury bond yield simultaneously be declining towards all-time lows?

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“Do I contradict myself?
Very well then I contradict myself,
(I am large, I contain multitudes.)”

Walt Whitman, Song of Myself

As the S&P 500 Index reaches all-time highs with an extraordinarily high valuation by most measures, how can the 10-year Treasury bond yield simultaneously be declining towards all-time lows?  Usually, stocks go up when investors are increasingly bullish about the economy, while Treasury bond yields typically fall when investors are increasingly bearish about the economy and inflationary prospects, but rising stock prices and falling bond yields are both happening at the same time today. The apparent contradiction is difficult to reconcile.

It may well be that we are witnessing a temporary anomaly which occasionally surfaces in the financial markets. For example, oil prices skyrocketed to $144 per barrel in 2008 at the same time that the housing bust and the financial crisis were starting to accelerate.  How could oil prices have risen to record highs just as aggregate demand was falling off a cliff? That anomaly corrected a few months later when oil prices declined by more than 75% to $34 per barrel.

Just as the oil price surge in 2008 turned out to be a temporary phenomenon, the conflicting signals between the stock and bond markets today may also be a short-term anomaly. If the stock market is correct and the bond market is mistaken, then bond yields should start to increase.  On the other hand, if the bond market is right, and the stock market is wrong, a correction in the stock market would likely be coming soon.

However, what if it is not an anomaly?

The Bond Market
A fundamental axiom of bond investing is that when bond prices increase, ceteris paribus, bond yields decline.  Similarly, when bond prices fall, bond yields rise. Needless to say, this relationship can be somewhat counter-intuitive.  From November 2018 through June 2019, 10-year U.S. Treasury yields declined from 3.23% to 1.99%, which is the lowest yield for 10-year Treasuries since 2016, a year in which 10-year Treasury yields hit a new all-time low of 1.36%. It seems strange for yields to compress in the face of a rising stock market, but several reasons could explain this phenomenon:

• Increasing Recession Concerns
Investors tend to buy U.S. Treasuries when they think a recession is imminent. The Treasury yield curve, which is currently inverted, is warning that a recession might be coming; the Federal Reserve Bank of New York uses the yield curve as an indicator to estimate that the chance of a recession within the next 12 months is as high as 33% (see chart to the right). The longer the yield curve remains inverted, the more likely it is that a recession is soon coming. Besides the inverted yield curve, which we wrote about in detail during our Q1 letter, other signals are also suggesting that the U.S. economy is, at the very least, slowing down if not approaching a recession. With growth slowing and the increasing possibility of a recession ahead, investors might be increasing their allocation to U.S. Treasuries, driving bond prices up and yields down.

 

• Increasing Pool of Retiree Investors
As the U.S. population ages and 10,000 new baby boomers enter retirement daily, investor demand for safety and yield should continue to increase. Retiree investors are less inclined to own an oversized allocation to risk assets like stocks, opting instead for U.S. Treasuries and other less volatile assets.  As demonstrated in the chart below, domestic investors have been purchasing an increasing share of U.S. Treasury auctions.  It is possible that the strength in bonds recently is partly attributable to increasing demand by domestic investors who are aging and seeking a safe haven, although it is difficult to understand why domestic demand for Treasuries would be discernably different today than it was eight months ago.

• Federal Reserve as a Treasury Buyer
Last year, the Federal Reserve reduced the size of its balance sheet by selling some of its U.S. Treasury holdings. This incremental supply increase pushed down Treasury bond prices and pushed up Treasury yields. However, with the stock market correction that took place in Q4 2018 and with economic numbers weakening, the Federal Reserve is signaling that it will soon cease its selling of U.S. Treasury bonds and begin to buy U.S. Treasury bonds once again. Whether it is to fund the U.S. budget deficit or to push investors back into riskier investments, the Federal Reserve is communicating to investors that large-scale asset purchases of U.S. Treasuries may soon resume.  Investors may be buying U.S. Treasuries now to front-run the Federal Reserve and enjoy the price appreciation that could take place once the Federal Reserve becomes a buyer again.

• Negative Yielding Foreign Bonds
As crazy as it may sound, a huge share of government debt across the world pays a negative yield, which means that investors in such bonds are paying government issuers to hold their money for them. A record $12.5 trillion of foreign bonds are now generating a negative yield, and that yield is becoming increasingly more negative as the global economy continues to weaken and as central banks communicate their willingness to do whatever it takes to provide additional monetary stimulus. While U.S. Treasury yields might appear to be low relative to what investors could earn twenty years ago, Treasury yields are high compared to most other sovereign debt in the developed world such as the debt of Japan, Switzerland, Germany, and Sweden.

Perhaps, then, the bond market is making sense. With the economy slowing, baby boomers aging, and the Federal Reserve increasingly inclined to become a Treasury buyer, many investors are finding Treasury bonds to be attractive.

The Stock Market
However, if all of the above is true, why is the S&P 500 Index testing all-time highs right now?

• Corporate Buybacks
With bond yields so low, it remains inexpensive for companies to issue bonds and use those bond proceeds to buy back their own stock. While corporate buybacks create weaker corporate balance sheets and amplify long-term stock market risk, they nevertheless create incremental short-term demand for shares and boost share prices. This trend has been driving the U.S. stock market for the past five years. Also, with corporate bond yields pitifully low, private equity funds can more easily finance the acquisition of publicly traded companies with cheap debt. While baby boomers might be reallocating their investments towards bonds, other investors, namely corporations and private equity firms, are using leverage to buy stocks.

• The Fed “Put”
The U.S. stock market, in many respects, has become a significant driver of the U.S. economy over the past 20 years. Pension plans depend on a rising stock market. So, too, do retirees. Employees with 401(k) plans, while not yet retired, have to increase their savings rate if the U.S. stock market does not continue to deliver attractive returns. The Federal Reserve knows this, and Federal Reserve monetary policy has evolved since the Financial Crisis to focus increasingly on preventing the stock market from correcting.  After the correction in December 2018, the Federal Reserve immediately stopped tightening and communicated a far more dovish monetary policy stance. Investors may be buying stocks because they expect the Federal Reserve will do whatever it takes to keep the stock market party going and it simply may be that “There Is No Alternative” to buying U.S. stocks (also known as the “TINA” effect).

• Inflation Hedge
The U.S. budget deficit is worsening due to increasing military expenditures, growing medical and retirement entitlements, recently enacted tax cuts, and rising debt service obligations, with no end in sight. At the same time, an emerging consensus is developing that the dollar is too strong relative to other currencies, making it difficult for U.S. manufacturers to compete. President Donald Trump and Senator Elizabeth Warren have both remarked recently that a weaker dollar is a critical factor to America’s future economic competitiveness, and economists like Harvard’s Carmen Reinhart advocate that the Federal Reserve should keep bonds yields well below the inflation rate to reflate the economy. While seemingly overvalued, stocks may be an attractive hedge for those investors looking for inflation protection.

• Interest Rate Manipulation
Because the Federal Reserve has enacted policies in recent years to influence not only the interest rate of short-term bonds but also the interest rate of long-term bonds, some investors do not believe that the yield curve provides a useful signal for upcoming recessions and are therefore less concerned about an imminent recession.

Unlike 2008, when the Federal Reserve appeared to be asleep at the switch, central banks around the world appear to be on alert today, for better or for worse, and stand ready to provide markets with liquidity to avoid another crisis. Ultimately, whether the rising stock market or falling bond yields are correct depends in no small part on whether the U.S. economy is entering a recession or just another soft patch.

If a recession is coming or has already arrived, corporate earnings are likely to fall, credit spreads should rise, and corporations will find it more expensive to issue bonds to buy back their own shares, all of which should result in a challenging market for stocks and bonds with high levels of credit risk. Under this scenario, we will be glad to have our clients invested in gold, Treasury bonds, and short-term, high-quality corporate bonds. These securities should provide portfolio stability as investors flock to safe-haven investments while the Federal Reserve cuts interest rates and once again expands its balance sheet to buy U.S. Treasuries.

On the other hand, if the economy is just going through a soft patch rather than a recession, the Federal Reserve’s monetary easing efforts during the second half of the year should reflate the economy and allow the stock market to continue rising, driven by corporate buybacks. Under this scenario, inflation expectations should increase once again along with economic growth as the soft patch recedes. Today, many of the more attractively priced stocks available are cyclical companies, with already pessimistic discounts due to increasing concerns about slowing growth, declining global trade, and growing geopolitical concerns.  Should growth re-accelerate, cyclical stocks and the stocks of companies that are exposed to global trade should perform well, similar to what happened in 2017 as economic expectations improved. Under this scenario, stocks could keep rising.

It is much less evident today than it was during the first half of 2008 that the economy is heading into a recession.  The New York Fed’s recession probability of 33% does not seem terribly off to us.  Of course, the New York Fed does not have a crystal ball on these matters — nor does anybody else.  Without knowing the future with any level of certainty, we are keeping our client portfolios diversified, with a constant eye towards committing capital to high-quality businesses which are selling at a sufficiently large discount to their fair values.

We would also suggest that it makes more sense for investors to focus on the big picture rather than what happens to the economy in the next few months.  As we see it, U.S. fiscal deficits are set to rise sharply in the coming decade, and it seems unlikely that foreign investors will pick up the tab. We expect the Federal Reserve to fill in the gap, buying U.S. Treasuries to fund these deficits.  This scenario is likely to cause the U.S. dollar to depreciate and create an environment where gold and stocks rise in nominal price while long-term Treasury bonds are unable to compensate investors adequately for the inflation risk they are taking.  As this occurs, the choice between more volatility and more inflation protection versus less volatility and less inflation protection will become an increasingly important topic of conversation for investors.


Thank you for your trust in asking us to build your financial plan and invest your capital in accordance with your risk tolerance, your life goals, and your investment values.  We hope you and your family have a wonderful summer.

Please do not hesitate to reach out to us with any questions.

This commentary is prepared by Pekin Hardy Strauss, Inc. (dba Pekin Hardy Strauss Wealth Management, “Pekin Hardy”) for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any security. The information contained herein is neither investment advice nor a legal opinion. The views expressed are those of the authors as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions. Although information has been obtained from and is based upon sources Pekin Hardy believes to be reliable, we do not guarantee its accuracy. There are no assurances that any predicted results will actually occur. Past performance is no guarantee of future results.

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The Costs of Long-Term Care https://pekinhardy.com/costs-of-long-term-care/ Mon, 17 Jun 2019 17:50:55 +0000 https://pekinhardy.com/?p=2518 Those preparing for retirement today should also seek to prepare themselves for a growing financial concern: long-term care. Long-term care is increasingly needed by people over the age of 65, can be very expensive, and is generally not covered by standard insurances, so retirees may find themselves unexpectedly facing large bills. With preparation, these costs are manageable, so those looking ahead to retirement should factor long-term care expenses into their planning.

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Those preparing for retirement today should also seek to prepare themselves for a growing financial concern: long-term care. Long-term care is increasingly needed by people over the age of 65, can be very expensive, and is generally not covered by standard insurances, so retirees may find themselves unexpectedly facing large bills. With preparation, these costs are manageable, so those looking ahead to retirement should factor long-term care expenses into their planning.


The Costs of Long-Term Care


Long-term care is a growing concern for retirees. Almost 70% of people turning 65 in 2019 will need some type of long- term care during their retirement for an average of three years.1 Long-term care can be extremely expensive, and retirees may be surprised to find that they lack insurance coverage to help them bear these costs.

Typically, long-term care is not medical care, but it is instead assistance with basic personal tasks like bathing, eating, and dressing. Some care also extends to household tasks, including housework, taking medication, and meal preparation and cleanup.2 Long-term care can be provided at home or in a range of nursing or assisted living facilities, depending on the needs of the patient.

In 2018, the national average annual costs for some common care services were as follows:

• $89,297 for a semi-private room in a nursing home

• $100,375 for a private room in a nursing home

• $48,000 for a one-bedroom in an assisted living facility

• $50,336 for a home health aide, 44 hours per week

• $48,048 for personal care assistance (personal care includes items like assistance with cooking, errands, maintaining a home, etc.), 44 hours per week

• $18,720 for health care day centers for adults, five days per week3

These costs vary by region. In the Chicago metro area, for example, a patient could expect to pay as much as $10,000 more than the national average for a private room in a nursing home or assisted living facility.

As long-term care becomes an increasingly common expense, retirees and their families need to plan for these costs above and beyond their anticipated medical spending in retirement.


Medicare and Medicaid


When considering healthcare planning in retirement, most people probably think of Medicare as the primary way to insure against health expenses. However, Medicare’s coverage of long-term care is much more limited than many people realize. On its own, Medicare is unlikely to be sufficient for many of those who require long-term care.

Medicare

Medicare generally does not cover long-term care if it isn’t associated with medical treatment.4 If a patient covered by Medicare needs to enter a long-term care facility purely for assistance with daily activities, that patient would be responsible for 100% of the costs associated with the facility. This typically means that stays in nursing homes are the patients’ financial responsibility.

Medicare will pay for some or all of the costs associated with long-term care if the care is skilled (for example, physical therapy rather than in-home meal preparation help), short- term, and deemed medically necessary. It often covers costs in a few specific circumstances:

After hospitalization: If a patient is hospitalized and then transfers to a nursing facility for continued care, Medicare will typically pay a portion of the costs for the first 100 days.

As treatment for a medical condition: If a doctor prescribes long-term care services to treat an illness or injury, Medicare will pay at least a portion of costs incurred for as long as is necessary. For example, if a patient required ongoing physical therapy, Medicare might pay for some expenses at a long-term care facility because it would constitute doctor-prescribed treatment.

To prevent decline: Medicare will sometimes cover long-term care for people with medical conditions that are unlikely to improve, like stroke, Parkinson’s disease, ALS, or Alzheimer’s.

Hospice care: Medicare will cover hospice care if a patient has been diagnosed with a terminal illness, is no longer seeking a cure, and is not expected to live more than six months.5

Medigap

Medicare Supplemental Insurance, or “Medigap,” is additional health insurance purchased from a private company that can help the insured with costs that aren’t covered under Medicare. However, they do not significantly expand the breadth of long-term care benefits. A Medigap policy might pay additional reimbursement if long-term care expenses already qualify for coverage under Medicare. The policies  do  not,  however,  change  eligibility  for  coverage, so a patient with a Medigap policy would still only be able to receive reimbursement under the specific scenarios permitted by Medicare.

Medicaid

Medicaid assists people with low income and/or low assets in paying for their healthcare costs. Those with significant retirement income and/or assets will not be eligible for the program, but it does provide a safety net for those whose assets may be depleted unexpectedly.

Unlike Medicare, Medicaid provides significant coverage for long-term care, but its strict eligibility requirements mean   that   fewer   people   qualify   for   the   assistance. Medicaid covers long-term care services in nursing homes and personal care services provided at home. Unlike Medicare, Medicaid will cover services that aren’t directly associated with medical treatment. Eligibility for Medicaid and Medicaid coverage of long-term care varies from state to state, so you should consult your local guidelines to see which expenses would qualify.


Other Options for Paying for Long-Term Care


Unless you qualify for Medicaid, you could find yourself shouldering significant and unexpected care costs in retirement. For those who wish to prepare for the possibility of needing uncovered care, there are a variety of ways to insure against a significant loss of assets should long-term assistance be needed.

Below, we review common options people may consider for long- term care coverage and how well they may or may not work.

We are happy to review any of the long-term care funding options that you may be considering for yourself.

Disability Insurance

When considering ways to pay for long periods of care, people often think of disability insurance. While disability insurance can be an important risk-mitigation tool, it does not cover long-term care services. Disability insurance also provides no benefits when the insured is over age 65, which is when he or she is most likely to need long-term care.

Life Insurance

Under certain circumstances, life insurance can help the policyholder pay for long-term care. These policies are as follows:

• Combination products: Some insurance companies are beginning to sell a combined life insurance/long- term care insurance policy, which ensures that the buyer will receive a benefit whether or not they require long-term care. These are relatively new products, and as such have changing features and benefits.

• Accelerated Death Benefits (ADBs): In some cases, the insured can add an Accelerated Death Benefit rider to their life insurance. This rider allows the insured to receive a tax-free advance on his or her life insurance while still alive, subtracting the amount used for care from the ultimate death benefit paid. Different types of ADBs cover different needs, but they will typically provide a cash advance in the event of a terminal or life-threatening diagnosis, a need for extended long-term care, or a permanent move to a nursing home. The monthly benefit is typically limited to two percent of the policy’s face value. ADBs often provide more limited payouts than a traditional long-term care policy.

• Life Settlements: At a certain age, policyholders can sell their life insurance policies at present value, potentially using the proceeds for long-term care. However, these settlements are taxable and eliminate the death benefit for heirs.

• Viatical Settlements: Terminally ill patients can sell their life insurance policies to viatical companies for a percentage of the death benefit, using the payment for needed end-of-life care. The settlement may be received tax-free. However, no death benefit will remain for heirs.

Long-Term Care Insurance

Long-term care insurance policies reimburse the policyholder a set amount per day to offset the costs of long-term care. Most policies are comprehensive and allow the insured to use their benefit at home or in a wide range of facilities including nursing homes, special care facilities for conditions like Alzheimer’s, and hospice. These policies typically differ in the maximum amount paid or length of time benefits will be distributed, with more benefit translating to a higher premium, and they often have different definitions of what constitutes a qualifying long-term care expense.

These policies offer extensive benefits in comparison to Medicare, but they are often extremely expensive and the amount of premiums paid can be wasted if the insured never requires long-term care.  In a previous Navigator, we weighed the costs and benefits of purchasing a long-term care insurance policy, and we encourage you to read about these policies in more depth if you are considering pursuing such coverage.

Private Health Insurance

Most health insurance follows the same rules as Medicare: long-term care services are only covered if they are skilled, short-term, and medically necessary, typically after a hospitalization. If long-term care qualifies for Medicare coverage, private health insurance may pay additional benefits towards those expenses.

Self Insurance

For those with significant savings, it’s possible to “self- insure” against long-term care needs simply by increasing the size of your asset base in retirement to account for the possibility of significant long-term care expenses. This avoids the possibility that you could pay expensive insurance premiums for years and never need long-term care, though it does require you to bear all the risk of care expenses.

A recent study from Fidelity estimated that the average couple will need $280,000 in today’s dollars for healthcare expenses during retirement excluding long-term care.6   Self- insurance against medical and long-term care needs is an expensive proposition for most families, but it could be the most suitable option for those with substantial asset bases.


How to Find Help


The Federal government offers many resources for people considering their long-term care options through the Department of Health and Human Services. Additionally, there is a wide range of nonprofits and community organizations that can also assist people in preparing for their care needs. AARP is one of the better-known examples, and their website has extensive resources for care-givers and care-receivers. Depending on where you live, there may also be services in your area through nonprofits or local government that can help you evaluate your needs and options.

There are also many elder care “consultants” available for hire. We would caution readers against retaining one of these consultants without thoroughly researching that consultant’s background beforehand. Many of these consultants may receive commissions to sell specific financial or insurance products and will likely not offer unbiased advice. Some nonprofits and religious and governmental organizations offer advice at an hourly fee and do not earn commissions, and we would generally recommend these types of consultants.

First and foremost, we invite you to discuss your long-term care plan with your Pekin Hardy Strauss advisor. We can evaluate the best options for your unique, personal needs and provide both recommendations for coverage and how to manage any additional premium expenses or savings goals. We can also consider long-term care as a part of a full financial plan. As a fee-only advisor and a fiduciary, we never take commissions for selling financial products or insurance, so you can trust that any recommendation we make is in your best interests. Please schedule a meeting with your advisor if you would like to explore this topic further.


1  https://longtermcare.acl.gov/the-basics/how-much-care-will-you-need.html

2  https://longtermcare.acl.gov/the-basics/what-is-long-term-care.html

3  https://www.genworth.com/aging-and-you/finances/cost-of-care.html

4  https://www.medicare.gov/coverage/long-term-care

5  https://longtermcare.acl.gov/medicare-medicaid-more/medicare.html

6 https://www.fidelity.com/viewpoints/personal-finance/plan-for-rising-health-care-costs

This article is prepared by Pekin Hardy Strauss, Inc. (“Pekin Hardy”,  dba  Pekin  Hardy Strauss  Wealth  Management) for informational purposes only. The information and data in this article does not constitute legal, tax, accounting, investment or other professional advice. The views expressed are those of the author(s) as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions.

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What Does a Chicago Bankruptcy or an Illinois Bankruptcy End Game Look Like? https://pekinhardy.com/what-does-a-chicago-bankruptcy-or-an-illinois-bankruptcy-end-game-look-like-2/ Sun, 09 Jun 2019 14:33:26 +0000 https://pekinhardy.com/?p=3774 Chicago and Illinois are in dire financial straits as a result of decades of financial mismanagement. While not yet technically bankrupt, Chicago and Illinois are headed into a bankruptcy-like restructuring of their financial obligations at some point within ten years.

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“How did you go bankrupt?’” Bill asked.
“Two ways,” Mike said. “Gradually and then suddenly.”

– Ernest Hemingway, The Sun Also Rises

Chicago and Illinois are in dire financial straits as a result of decades of financial mismanagement. While not yet technically bankrupt, Chicago and Illinois are headed into a bankruptcy-like restructuring of their financial obligations at some point within ten years. I have formed this opinion without any inside knowledge of Chicago or Illinois politics. My view is based on math and an understanding of the power of compound interest.

What Happens to Chicago as it Approaches the End of the Road?

If you are a saver and an investor, the law of compound interest is a wondrous phenomenon. With compound interest, your net worth grows over time as you generate income on your invested capital which you can then reinvest to generate even more income.  It’s particularly important to save early in your life, so that time and the compound interest has more time to grow before your retirement.

If you are a significant debtor, as Chicago and Illinois are, the law of compound interest is a toxic force which can drive you into bankruptcy just as soon as its lenders stop providing the financing. Moreover, compound interest can be particularly toxic if a municipality mismanages their finances for decades, which Chicago and Illinois have, in my opinion.  With compound interest, debts and pension deficits compound over time until they eventually become unmanageable.

After many years, the debt level and pension obligations of Chicago and Illinois have already become so large that there is I don’t believe there’s any way out, short of a miracle (such as a Federal bailout).  Moreover, as time goes on, these liabilities will continue to compound and grow larger, making the cost of an ultimate resolution even larger for all stakeholders involved.

Brief Overview and Quantification of the Financial Problem for Illinois and Chicago

For Illinois, the state currently had $28 billion in general obligation (GO) bonds, $15 billion of unpaid bills, and, most importantly, an unfunded pension liability which grew to $133.5 billion on June 30, 2018. Governor Pritzker recently signed a budget law which is supposedly balanced, but the budget balances only by shortchanging Illinois pensioners by avoiding an actuarial $4.9 billion pension payment.

Illinois currently has a credit rating just above junk. Reflecting the decline in the financial position of the state, Illinois has been downgraded 21 times since 2009.  This makes it more difficult and more expensive for Illinois to issue debt.  Moreover, there’s an increasing risk that eventually the bond market will decide that Illinois isn’t worth financing at any price that the state can afford.

Unlike Illinois, Chicago’s bonds are already junk rated (Ba1) by Moody’s. Relatedly, the deep junk bonds of the Chicago Board of Education, are rated B2.  The pension systems of Chicago and the Chicago Public School system are also deeply underfunded, by $42 billion.

As a result of these increasingly costly obligations, a larger and larger share of the budget for both the state of Illinois and the city of Chicago are going towards pension payments.  For example, according to Illinois Policy Institute, Illinois pension expenses have risen from 4% of the budget in 1990 to 27% in 2018. This is why taxes are rising at the same time that services are declining.

Here is how the vicious cycle is currently working:

  1. Debts are rising exponentially.
  2. Pension underfunding levels are also increasing exponentially.
  3. Because of #1 and #2, interest payments and pension obligations are consuming a larger portion of state and city budgets.
  4. Because of #3, taxes and fees keep rising, while service levels keep declining.
  5. Because of #4, taxpayers are leaving the city and state, making the financial problems even worse.

It’s obviously not a pretty picture. It’s easy to blame current politicians for the current mess, but the truth is that everyone is doing their best to sort through a bleak and impossible-to-fix financial mess.

How Are You Going to be Affected by This?

The fiscal quagmires in Chicago and Illinois will cause significant problems for many people:

  • If you are a resident or business owner in Chicago or Illinois, this could affect your taxes and your property value. Services will also keep declining, which could mean fewer police officers and larger classroom sizes.
  • If you are a current or former employee of the city of Chicago or the state of Illinois, this could affect your job, your salary, and your pension.
  • If you are a municipal bond investor who bought Chicago and Illinois muni bonds due to the juicy yields they provide, this could affect your ability to get 100% of your principal back.
  • If you are a municipal bond insurer, you might have a significant financial obligation if Chicago or Illinois default on their bonds.
  • If you are one of the cities and states across the country with similar pension problems as Chicago, this could raise the interest rate that you have to pay for the bonds that your municipality issues.
  • If you are a S. policymaker, this could create financial instability that might hurt the fragile U.S. economy.

In short, this is a problem will directly or indirectly affect many people.

which are strategically located in the Mediterranean Sea and coveted by China. Greece sold the Port of Piraeus to China to raise much-needed funds. Chicago has Navy Pier and Oak Street Beach, which are both great places, but China couldn’t care less about them.

A Framework for Interpreting Future Events as they Unfold

As the finances of Chicago and Illinois continue to worsen at an accelerating pace, it’s important to keep the following five ideas in mind:

#1: Illinois and Chicago policymakers will do their best to kick the can down the road to delay a reckoning.  Politicians do not want to see a bankruptcy on their watch.  Instead, they will continue to provide band-aids, hoping that they will be out of office by the time a default happens.  I don’t believe politicians ever choose to make unpopular decisions until outside forces force the issue, and all of the choices they currently face are unpopular ones.

#2: Two chances exist for a grand compromise fix: slim and none.  In the current partisan environment, Republicans will almost certainly avoid compromises that result in higher taxes, while Democrats will resist any compromises that cut spending.  Also, even if there is a grand compromise, the toxic force of compound interest is too large to stop at this point.

#3: The longer the wait, the worse it will be for all stakeholders in the end.  The delay until an eventual default is bad for almost all stakeholders involved except the political class.  With continued delay…

  • …the pension underfunding situation will worsen, harming pensioners who are counting on Chicago and Illinois to deliver on their promises.
  • …city and state services will continue to decline, which will affect the effectiveness of the schools, public safety, and the quality of life.
  • …more taxpayers will flee the state due to declining services and higher taxes.
  • …and the debt burden of Chicago and Illinois will worsen, as the city and state issue more bonds to push off the inevitable.

#4: There’s a reasonably good chance for a Federal bailout.  The Federal Reserve does not want to create financial instability because the U.S. economy is just too fragile to handle it.  To provide financial stability, the Federal Reserve has already provided capital to support or bail out banks, the housing market, stocks, bonds, and mortgage-backed securities during the past decade.  The municipal bond market is an enormous, $3.7 trillion market, and, according to Bloomberg, the municipal pension under funding situation nationwide is approaching $2 trillion. These figures are easily large enough to get the attention of Congress, the Federal Reserve, and President Trump.

#5: If a default occurs, expect a wealth transfer from creditors to debtors.  Investors in Chicago municipal bonds and Illinois municipal bonds, who are typically high net worth individuals in the highest income tax bracket, will see steep haircuts on their investment principal if a default occurs. Pensioners, which include middle-class retirees, many of whom used to be teachers, policemen, and firemen, should fare much better.

What is the Likely Catalyst for a Chicago Bankruptcy or an Illinois Bankruptcy?

As long as investors are willing to buy the municipal bonds issued by Chicago and Illinois, the dance will continue as the level of financial distress slowly worsens.  To use Hemingway’s terminology, Chicago and Illinois are still in the gradual phase of becoming bankrupt.

The sudden phase of bankruptcy, in all likelihood, occurs when one or more of the following occurs:

  • The economy enters another recession, which would have a detrimental impact on tax revenues.
  • The stock market declines significantly, which would blow a large hole in pension plans that are dependent on 7% annualized investment returns.
  • The bond market decides it doesn’t like risk anymore, which would make it difficult and prohibitively expensive for municipalities with a risky credit profile to issue more debt.

How Does this Affect Your Financial Situation?

I don’t know what your individual financial situation is, so it’s impossible for me to provide specific personalized financial advice.  However, I will provide make some general comments.

  1. If you are a resident of Chicago or a resident of Illinois, it would be prudent to prepare and budget for higher taxes in the future.
  2. If you are a municipal bond investor, you might want to consider investing in municipal bonds outside of Illinois where the risk/reward profile looks more attractive.
  3. If you are a current or prospective investor in Chicago real estate, you should prepare and budget for your property taxes to rise.

Have you factored the fiscal problems of Illinois and Chicago into your financial plan?  Please do not hesitate to reach out to us to discuss.


This information is prepared by Pekin Hardy Strauss, Inc. (Pekin Hardy) for informational purposes only and is not intended as an offer or solicitation for business.  The views expressed are those of the author as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions. The information and data in this article does not constitute legal, tax, accounting, investment or other professional advice. Pekin Hardy cannot assure that the strategies discussed herein will outperform any other investment strategy in the future, there are no assurances that any predicted results will actually occur.

 

 

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Five Tax-Saving Strategies for the Trump Era https://pekinhardy.com/five-tax-saving-strategies-for-the-trump-era/ Thu, 02 May 2019 17:50:55 +0000 https://pekinhardy.com/?p=2518 Minimizing taxes is important in building and protecting wealth over the long-term.  However, navigating the highly complex and ever-changing tax code is not an easy task.  The Tax Cuts & Jobs Act (often referred to as the “Trump Tax Cuts”) included a number of changes to the Federal tax code that will have a material impact on many Americans. You should understand these changes and be aware of tax strategies that could reduce your taxes under this new act.

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the navigator

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Minimizing taxes is important in building and protecting wealth over the long-term.  However, navigating the highly complex and ever-changing tax code is not an easy task.  The Tax Cuts & Jobs Act (often referred to as the “Trump Tax Cuts”) included a number of changes to the Federal tax code that will have a material impact on many Americans. You should understand these changes and be aware of tax strategies that could reduce your taxes under this new act.  Accordingly, the purpose of this Navigator is to help readers make sense of some of the new tax rules associated with the TCJA and to discuss certain strategies that may help taxpayers minimize their tax burdens under these new rules.


Key Tax Law Changes Under the TCJA


In December of 2017, Congress passed the most sweeping tax reform bill in more than three decades. Officially known as the Tax Cuts & Jobs Act (TCJA, or The Act), the new legislation is complex and affects individuals and businesses in varying ways. Many of the changes affect corporations or small numbers of taxpayers with unique circumstances, so we will not focus our attention on those changes.  Instead, we focus below on the major changes that are likely to affect a larger percentage of individual taxpayers.

  • Tax bracket changes
    There are still seven tax brackets under the new law, but many of the rates were lowered and the income thresholds associated with each bracket were adjusted. The tables below show the old and new Federal tax brackets for both individuals and married couples filing jointly.1

  • Personal exemption eliminated
    The personal exemption that was available to most taxpayers under previous law has been eliminated. Prior rules allowed for an exemption of $4,050 for each person who could not be claimed as a dependent by someone else. Under TCJA, no personal exemptions will be allowed.

  • Increased Standard Deduction
    The standard deduction was increased from $6,350 to $12,000 for individuals and from $12,700  to $24,000 for married couples filing jointly.


  • State and local tax (SALT) deductions capped
    Deductions for state and local taxes (state income taxes, property taxes, etc.) are now capped at $10,000. Taxpayers with state and local tax burdens in excess of $10,000 will no longer be able to fully deduct their state and local taxes as they did in past years.

  • Mortgage and home equity debt interest deduction limited
    Under previous law, taxpayers could deduct interest paid on qualified residence acquisition indebtedness up to $1,000,000, plus an additional $100,000 of home equity-based debt.2 The limit on acquisition indebtedness has now been reduced to $750,000 for mortgages obtained after 12/15/2017.3 Additionally, interest on home equity-based debt that is used for purposes other than to improve the property securing the debt will no longer be deductible.

Given the rule changes listed above, as well as other changes included in the  TCJA, there are a number of strategies that taxpayers may employ to minimize their tax burdens. Below are five strategies that readers may want to consider, depending on their own personal tax circumstances.


Strategy 1:
Contribute to a Donor-Advised Fund


The combination of a significant increase in the standard deduction and the limiting or disallowance of many deductions has made donor-advised funds a hot topic in 2018. We published a Navigator focused specifically on the subject of donor-advised funds last year, outlining ways in which some taxpayers may be able to enjoy material tax savings through the use of donor-advised funds.

We will not go into the same level of detail here as we did in the previous Navigator but, rather, outline the basic strategy. Taxpayers who make charitable donations but whose total deductions fall short of the standard deduction can contribute several years’ worth of charitable donations to a donor-advised fund in a single contribution and then deduct that entire amount on a single year’s tax return. The money can then be doled out by the donor at his or her discretion over any time period. By bunching multiple years’ worth of charitable donations into a single charitable contribution towards a donor-advised fund, you can ensure that you exceed the standard deduction in the year that you make a contribution and get the full tax benefits of your charitable donations.


Strategy 2:
Pay Off Home Equity Loans or Lines of Credit


Prior to the passing of the TCJA, interest on home equity loans and lines of credit were tax-deductible up to the $100,000 debt limit, no matter the use of the proceeds. This made HELOCs a very versatile and cost-effective source of credit for many people. However, interest on home equity indebtedness (loans or lines of credit) is now only deductible if the proceeds of the indebtedness are used to “substantially improve” the home securing the debt. This means that interest on home equity debt used to pay for personal expenses, college tuition or a vacation can no longer be deducted on one’s taxes. However, if the home equity debt is used to pay for home addition or a kitchen renovation, for example, then the interest can still be deducted.

This is an important change for many taxpayers, as home equity debt is often used as a low-cost source of funding for large purchases, education expenses, and other purposes unrelated to home improvement. Accordingly, you may want to consider paying off home equity debt that was used to fund anything other than home improvements, as the cost of this funding is now materially greater than it was prior to the passing of the TCJA.


Strategy 3:
Use 529 Plan Assets to Pay for Elementary or Secondary School


As college savings vehicles go, few are more popular than 529 plans, which allow families to set aside assets to be used for future education expenses and invest those assets in a tax-advantaged manner in the meantime (see our Navigator on college savings strategies for a closer look at 529 plans). While 529 plans have long played a significant role in many college savings strategies, their utility was further increased by the TCJA.

Previously, investment earnings in 529 plans could only be withdrawn tax-free if used for qualified education expenses at colleges, universities, vocational schools or other postsecondary institutions as specified by the Department of Education. Under the TCJA, however, the list of qualified schools has now been expanded to include elementary and secondary public, private, or religious schools, up to an annual limit of $10,000. This means that families may withdraw up to $10,000 per year per student from 529 plans without penalty in order to cover education costs for children in elementary, middle or high school. However, the deductibility from state taxes of 529 plan contributions that are then used for elementary or secondary school varies based on the regulations of each state.


Strategy 4:
Make a Qualified Charitable Distribution


Taxpayers above the age of 70 ½ who are subject to required minimum distributions (RMDs) and who make charitable donations can enjoy significant tax savings by making those donations directly from their IRAs or other qualified accounts. Known as a “qualified charitable distribution,” such a donation counts toward one’s RMD requirements but is excluded from income for tax purposes. While charitable donations are often counted as deductions against income, in this case they are actually excluded from income. This is an important distinction: seniors are less likely to exceed the new, higher standard deduction level given that they tend to have fewer deductions than younger taxpayers. Qualified charitable distributions allow these taxpayers to support their favorite charitable organizations while still receiving tax benefits, whether they itemize deductions or not. Thus, if you are receiving RMDs and are charitably inclined, you should prefer to make a qualified charitable distribution from your IRA rather than setting up a donor-advised fund, because a qualified charitable distribution reduces your taxable income dollar for dollar and is not subject to any standard deduction limitations.


Strategy 5:
Consider Moving


The tax-saving benefits of living in a state with low income and property taxes are obvious at the state level, but the TCJA makes it even more attractive to live in a low-tax location because of the cap on deductibility of state and local taxes (SALT) at the Federal level. The cap on SALT effectively punishes taxpayers who live in high tax states and/ or municipalities, as many of these taxpayers will be unable to fully deduct their state and local taxes from their Federal taxes, resulting in a larger Federal tax burden than under previous rules.

Prior to the passing of the TCJA, taxpayers were able to deduct from their Federal taxes all state and local income taxes and property taxes, no matter the amount. Under the new rules, however, many taxpayers are only able to deduct a portion of those taxes, as the $10,000 cap is far below the total that many taxpayers hand over to state and local tax authorities. Taxpayers living in states that do not levy state income taxes may still deduct sales taxes and property taxes that they paid throughout the year on their Federal tax return up to $10,000.4

While picking up and moving to another city and/or state to take advantage of lower taxes is clearly not feasible or desirable for many people, it could be a powerful tax-saving strategy for some. That being said, it is almost guaranteed that legislators will change the tax code many times in the future; moving locations based on the deductibility of SALT at the Federal level alone may end up providing just a short- term benefit.


Closing Thoughts


Obviously, the strategies discussed above are far from exhaustive. The Federal tax code is a vast maze of rules, often with multiple interpretations, loopholes, and restrictions. The tax-minimization strategies that are best for you will depend on your unique situation, and you should discuss any potential strategies with a tax professional. Our goal in addressing this topic is simply to help readers better understand some of the more important changes that were implemented with the passing of the Tax Cuts & Jobs Act and suggest some simple strategies that may help you reduce your tax burden in this new tax paradigm. If you would like to discuss these or any other tax strategies, please call or email us.


1  Taxpayers who file under other statuses should refer to the IRS website for updated tax bracket information.
https://www.irs.com/articles/2018-federal-tax-rates-personal-exemptionsand-standard-deductions

2  Qualified residence acquisition indebtedness refers to a mortgage that is secured by a primary or secondary residence.

3  Mortgages obtained prior to this date are “grandfathered” and remain subject to the previous limits.

4  Residents of states that do levy state income taxes may also deduct sales taxes, but they may not deduct both sales taxes and state income taxes; they must choose one or the other. In most cases, state income taxes far exceed sales taxes paid for taxpayers living in states with income taxes.

This article is prepared by Pekin Hardy Strauss, Inc. (“Pekin Hardy”, dba Pekin Hardy Strauss Wealth Management) for informational purposes only. The information and data in this article do not constitute legal, tax, accounting, investment or other professional advice. The views expressed are those of the author(s) as of the date of publication of this report and are subject to change at any time due to changes in the market or economic conditions. Pekin Hardy cannot assure that the strategies discussed herein will outperform any other investment strategy in the future, there are no assurances that any predicted results will actually occur.

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The Impact of Inverted Yield Curves https://pekinhardy.com/the-impact-of-inverted-yield-curves/ Mon, 22 Apr 2019 16:00:31 +0000 https://pekinhardy.com/?p=2971 In our most recent investor commentary, we discussed the drivers for the stock market downturn during Q4 2018. We suggested that monetary tightening from central banks across the world was the primary culprit in deflating equity prices. Specifically, we postulated that markets would remain weak without a reversal in quantitative tightening. And, in January 2019, the Federal Reserve did a stunning about-face and reversed its interest rate tightening stance. This policy reversal helped to drive the U.S. equity markets to the best start to the year since 1998.

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“Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.”

− Lao Tzu

In our most recent investor commentary, we discussed the drivers for the stock market downturn during Q4 2018. We suggested that monetary tightening from central banks across the world was the primary culprit in deflating equity prices. Specifically, we postulated that markets would remain weak without a reversal in quantitative tightening. And, in January 2019, the Federal Reserve did a stunning about-face and reversed its interest rate tightening stance. This policy reversal helped to drive the U.S. equity markets to the best start to the year since 1998.

The Federal Reserve’s reversal also sparked rising bond prices, and the corollary to higher bond prices is lower interest rates. However, a particularly foreboding sign raised its ugly head in the debt markets for the first time since 2007 − the U.S. Treasury yield curve inverted in late March 2019. Historically, this unique anomaly has occurred when GDP growth is slowing, when the risk of recession is increasing, and/or when investors expect central banks to reduce short-term interest rates – much like we discussed at length in our January investor letter.

The Inverted Yield Curve
The yield curve is defined as the relationship between short-term and long-term interest rates of government debt. Most of the time, short-term interest rates are lower than long-term interest rates, so the yield curve slopes upwards, reflecting higher returns for longer-term bond investments. In the United States, the short-end of the yield curve is controlled by the Federal Reserve, which sets short-term interest rates. The long-end of the yield curve is generally governed primarily by inflationary expectations, which are subject to the whims of bond market participants.1

Intuitively, it makes sense for long-term interest rates to be higher than short-term interest rates. Investors typically expect to get paid more for tying up their capital for a longer period of time. For most of the past decade during which the economy has been growing steadily, investors have faced an upward-sloping yield curve. On the graph on the next page, the blue yield curve from five years ago (3/31/2014) is a prime example of an upward-sloping yield curve, and a more gentle but still upward-sloping example is the yellow yield curve from one year ago (3/31/18) on the same graph.

Late in economic cycles, the yield curve often flattens.  As economic activity reaches a more mature part of the cycle, short-term interest rates tend to increase.  At the same time, the long-end of the yield curve can be pressed downwards as investors increasingly expect weaker GDP growth and inflationary expectations.

Sometimes, the yield curve inverts, as it did in late March 2019.  In an inverted yield curve situation, long-term interest rates are lower than short-term interest rates, which, on the surface, seems counterintuitive.  The inverted red yield curve in the graph below is a reflection of the last trading day of this past quarter.

The Cause of Yield Curve Inversions
As recessionary fears increase, long-term interest rates trend lower in reaction to increased buying of long-term Treasury bonds.  Investors who worry about recession become inclined to buy longer-term securities immediately to lock in higher current yields, coincident with falling inflationary expectations.

Contemperaneously, late in the economic cycle, the Federal Reserve often increases interest rates to dial down economic growth and tamper inflation, which keeps the short-end of the yield curve high.  With higher short-term rates and lower long-term rates, lo and behold, the yield curve inverts.

The Impact of an Inverted Yield Curve
The influence of an inverted yield curve can be significant.  When the yield curve inverts (even by just a very small percentage, like it did recently), it reflects the fact that investors believe that the risk of recession is accelerating.

The chart at the top of the next page shows the yield spread between the 10-Year Treasury bond and the 90-Day Treasury bill.  Any data points below the black line reflect a period of time when the yield curve was inverted.  As demonstrated, an inverted yield curve preceded the last three recessions.  In fact, the inversion of the yield curve occurred before every single one of the post-World War II recessions.

When the yield curve is steep and upward-sloping, it typically points to higher inflation, which is, in turn, associated with faster economic growth in the years to come than in the immediate future.  Of course, when the yield curve is inverted, the curve implies slower economic growth and lower inflation in the years to come.

However, an inversion is not just a technical market signal; its very shape reduces profitability for the banking sector.  If bank assets (loans with longer maturities) generate less income than bank liabilities (short-term customer deposits), then banks have little incentive to make new loans.  As a result of declining credit availability, economic growth starts to slow.  Furthermore, banks tend to tighten lending standards when the yield curve inverts, making it incrementally harder for borrowers to obtain loans.  Thus, the yield curve can be viewed as more than just a leading indicator for future recessions; its inverted shape can also help to cause recessions.

From the perspective of investors, yield curve inversion eliminates the risk premium for long-term fixed income investments, allowing investors to obtain attractive yields with short-term debt investments.  Plus, one often sees the risk premium between short-term Treasuries and riskier investments narrow, thus making short-term Treasuries and other short-term high-grade fixed income securities relatively more attractive.  In addition, due to an increasing risk of recession, investors often get nervous about owning stocks when the yield curve inverts.

Is This Time Different?
Famed investor Sir John Templeton correctly pointed out that the phrase, “This time is different,” have been proved time and again to be the most expensive four words for investors.  In 2000, consensus thinking was that the fiscal surplus and the dearth of longer-dated Treasuries would cause the inverted yield curve signal to be less relevant.  The subsequent Dot-Com implosion proved this theory wrong.  And, in 2006-2007, both consensus thinking and former Federal Reserve Chairman Ben Bernanke believed that the inverted yield curve was not a useful economic indicator due to the global savings glut at the time.  The subsequent housing bust and Credit Crisis also proved them wrong.

As for today, former Federal Reserve Chairman Alan Greenspan is among the market pundits who believe that the recent yield curve inversion is a false recession indicator, since, in his view, long-term bond prices are buoyed by heavy investor demand.  Given the recent exuberance of the stock market, it is apparent that stock market investors also do not believe, at least for now, that a recession is forthcoming anytime soon.

Indeed, we would be remiss not to mention the fact that there are unique aspects to the economic situation today that could limit the predictive impact of the recent inverted yield curve:

  • Markets are highly manipulated.
    After a decade of unprecedented market manipulation by the Federal Reserve and other central banks, long-term interest rates across the world stand at historically low levels.  The global bond market is roughly $100 trillion in size, and close to 8% of the total bond market shockingly now sports a negative yield as a result of intensive central bank bond manipulation.  To some investors, the manipulation of the capital markets makes it difficult to point definitively at an inverted yield curve as an accurate market predictor.
  • Financial regulations have caused financial institutions to buy more Treasuries.
    Following the Financial Crisis, new financial regulations were put into place to ensure a more robust banking system.  One new regulation is the liquidity coverage requirement, which requires financial institutions to hold a higher amount of high quality liquid assets (i.e., Treasuries).  As a result, financial institutions have become a price-insensitive buyer of long-dated Treasury bonds.
  • The Federal Reserve seems to be more reluctant to raise rates.
    The Federal Reserve does not want to catch the blame for dampening economic growth.  It seemingly only plans on raising rates significantly until after they see an actual, sustained spike in inflation rates.
  • The inversion has already reversed itself.
    The yield curve inversion only lasted a few days; as of this writing, the yield curve is now ever-so-slightly upward-sloping.  Plus, the yield curve was inverted for a short time, so it is possible that it was nothing but a head fake.
  • Policy changes could stimulate the economy.
    Policy-driven catalysts could drive asset prices upwards, including but not limited to:

    • A resolution of the U.S./China trade war and/or a negotiated decline in the value of the U.S. dollar, similar to what transpired at the 1985 Plaza Accords, could be highly stimulative for the U.S. economy.
    • Increased quantitative easing, likely in the form of interest rate cuts, could nudge investors back into risky assets.

Historically, the inverted yield curve has been a useful leading indicator of weakening economic activity.  Of course, we simply do not know if it will continue to work in the future based on the reasons listed above, but there is no structural reason to think that the indicator has broken down.  In short, our view is that we see little compelling evidence to convince us that it is different this time.  We would suggest that the chance of recession has increased significantly in recent months.


Following the wise words of the famed Chinese philosopher, Lao Tzu, we try not make significant investment decisions based on any sweeping predictions.  Yes, the inverted yield curve sends an ominous signal, but we continue to believe it is prudent to own a diversified portfolio of uncorrelated, reasonably valued asset classes. Due to elevated equity valuations, we remain underweight stocks compared to our strategic allocation targets. Many stocks have a poor risk-reward profile currently, but not all, and we are unafraid of buying the shares of those stocks that are priced attractively. We are also increasing our allocation to foreign stocks, whose valuations are less lofty. With your fixed income investments, we are continuing to keep bond maturities short and credit quality high.

To be fair, please keep in mind that the best way to plan for a recession on an individual level is to try to make prudent overall financial choices, exactly as you would even if you did not believe that a recession was likely in the near term.

We thank you again for trusting us as your financial advisor.  We hope that you will not hesitate to reach out to any of us with your questions and concerns.

Sincerely,

Pekin Hardy Strauss Wealth Management

This commentary is prepared by Pekin Hardy Strauss, Inc. (dba Pekin Hardy Strauss Wealth Management, “Pekin Hardy”) for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any security. The information contained herein is neither investment advice nor a legal opinion. The views expressed are those of the authors as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions. Although information has been obtained from and is based upon sources Pekin Hardy believes to be reliable, we do not guarantee its accuracy. There are no assurances that any predicted results will actually occur. Past performance is no guarantee of future results.

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The Vital Importance of IRAs https://pekinhardy.com/the-vital-importance-of-iras-3/ Mon, 11 Mar 2019 18:36:23 +0000 https://pekinhardy.com/?p=2474 We have published this Navigator at this same time each of the past several years in order to highlight the importance of IRAs and to encourage our clients to make their annual IRA contributions prior to the tax filing deadline.

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We have published this Navigator at this same time each of the past several years in order to highlight the importance of IRAs and to encourage our clients to make their annual IRA contributions prior to the tax filing deadline.

Read More

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