Financial

By Sarah Ruef-Lindquist
Originally Submitted to the Pen Bay Pilot Wave

Many investors have a chunk of their portfolio in a fixed income allocation; that could include domestic and international corporate bonds of varying grades of credit quality and domestic municipal or government issued bonds. Very often “balanced” allocation strategy will anticipate a lower level of volatility and a lower growth in value potential through bonds, while anticipating the yield bonds generate providing income to investors that may be higher than many dividend-producing stock.

An often-used allocation strategy is 60/40: 60% stock, 40% fixed income. Extolling the virtues of this approach on their website, Vanguard reminds us:

Portfolio outcomes are primarily determined by investors’ strategic asset allocations. And this is good news because, with proper planning, investors with balanced portfolios should be well-positioned to stay on course to meet their goals, instead of swerving to avoid bumps in the road. 

Since the Great Recession, in a low interest-rate environment, yields on US bonds have been more modest, reducing the amount of income investors can expect from them. However, they have tended to provide a cushion in overall value dips, because of their lower level of volatility in comparison to the holdings within the stock allocation.

But now rates are rising; the Federal Reserve is working to reduce the growth of inflation by making money more expensive to borrow than it has been in over a decade, curbing borrowing, and that’s pushing rates higher.

Higher rates are great for new bonds and their investors…but it can depress the relative value of existing bonds with lower rates. In the current market downturn in the first quarter of 2022, what investors are seeing is not only a dip in the value of their stock portfolios after reaching historic high values, but a decline in the value of their bond portfolios as well. That’s painful. Many are scratching their heads.

Two things to remember about bonds:  their relative value may be lower, but they still have their yield, or income. Secondly, when a bond matures, it almost always pays the investor back the original value of the bond, even though it’s value on paper has reflected a lower “market value” during the period of rising rates. The more patience an investor can exercise over their bond portfolio in these times, the greater the reward.

As you monitor the health of your investment portfolio with your financial and investment advisor, be sure your allocation strategy fits your own unique goals and risk tolerance.

Image source. 

There were many who predicted significant changes to the current federal estate and gift tax law in the past year, but nothing has materialized as of this writing.  Many predicted that the amount that would be subject to tax would be greater due to a lowering of the exemption amount, and that the rates would be higher. It just didn’t happen. Indeed, the exemption is going up.

According to the IRS website and Kiplinger, the federal estate tax exemption is going up for 2022. The amount is adjusted each year for inflation. It’s important to remember that the current law will sunset at the end of 2025, at which point the amounts and rates will revert to those in effect in 2016, which are significantly lower, meaning more estates will be taxable.

2022 Federal Estate Tax Exemption

Generally, when you die, your estate is not subject to the federal estate tax if the value of your estate is less than the exemption amount. For people who pass away in 2022, the exemption amount will be $12.06 million ($11.7 million for 2021). For a married couple, that comes to a combined exemption of $24.12 million.

This is also known as the Basic Exclusion amount. It is as high as it’s ever been. The annual exclusion for gifts was $11,000 (2004-2005), $12,000 (2006-2008), $13,000 (2009-2012) and $14,000 (2013-2017). In 2018, 2019, 2020, and 2021, the annual exclusion is $15,000. Again, in 2022, the annual exclusion is $16,000.

Federal Estate Tax Rate

Only a small percentage of Americans die with an estate worth $12 million or more. But for estates that do, the federal tax bill is significant. Most of the estate’s value is taxed at a 40% rate.

According to Kiplinger, the first $1 million in an estate is taxed at lower rates – from 18% to 39%. That results in a total tax of $345,800 on the first $1 million, which is $54,200 less than what the tax would be if the entire estate were taxed at the top rate. Once the estate’s value exceeds $1 million, the excess is taxed at the 40% rate.

That’s the picture from a federal perspective. What about Maine? Yes, Maine has an estate tax, with an exemption level of $5.87 million. The Estate tax rates range from 8% – 12%, which is one of the lowest rates among the states that have an estate tax. There is no tax on heirs, so no Inheritance tax.[1]

Federal Gift Tax

Gifts can be taxable if they are big enough. First, there’s the exclusion of what you don’t need to report each year. This would apply to gifts to any one individual in the calendar year by a taxpayer. You could double the amount for gifts from a married couple filing jointly. The current exclusion is $16,000. It has increased over the years. Those gifts that exceed the exclusion Amount are reported and cumulatively are not taxable as gifts until they exceed a total of the exemption amount during your lifetime, currently over $12 million.

By the time 2026 rolls around, we will likely hear much more about estate and gift taxes. The current law is slated to sunset December 31, 2025 and go back to 2016 levels January 1, 2026.

All taxpayers should consult with their own professional tax and legal advisors when making estate and significant gifting plans to take their unique facts and circumstances into account.

[1] https://www.kiplinger.com/retirement/inheritance/601551/states-with-scary-death-taxe

Fixed income investments (also known as bond investments) play an important role in a well-diversified portfolio, potentially serving as downside protection in times of uncertainty. Still, as of this writing in January 2022, some fixed income investors are understandably cautious about the risk of rising consumer prices on their portfolios. The primary concern is the potential for interest rates to increase.

Rising interest rates put pressure on fixed income investments by causing prices for existing bonds to fall. This is known as interest rate risk. Although there is no way to completely avoid the impact of higher inflation on fixed income, the risk can be mitigated. Let’s review four strategies that could help manage fixed income portfolio risk.

1) Reduce Interest Rate Risk

Why is interest rate risk a primary concern for many bond investors? After all, a bond’s original terms do not change within the interest rate environment. If you hold a bond to maturity, you’re entitled to receive the full principal amount, plus any outstanding accrued interest.

If you want to sell a bond before maturity, however, the situation is different. Prior to maturity, most existing bonds sell at a premium or a discount to the full principal amount, plus accrued interest. If interest rates have risen since a bond was issued, the price of the bond typically declines.

So, what strategies can we employ to potentially reduce the interest rate risk of a bond portfolio? Adjusting the duration of your bond portfolio is one of the first methods to consider. Duration is a measure of the sensitivity of the price of a bond to a change in interest rates. Notably, duration is not the same thing as a bond’s term to maturity.

For instance, a bond with a duration of 5 would be expected to see its price fall 5 percent if interest rates were to rise by 1 percent. In comparison, a bond with a duration of 2 would be expected to see a 2 percent decline if interest rates were to rise by 1 percent.

To guard against a rise in rates, it might help shorten the duration of your bond portfolio. It’s important to note, though, that shortening duration alone may not ensure that a portfolio is adequately protected while generating a reasonable return.

2) Increase Credit Spread Risk

A credit spread is the difference in interest rates between a U.S. Treasury bond and another type of bond of the same maturity but different credit quality. Typically, bonds with a lower credit quality offer higher interest rates than U.S. Treasury bonds. The risk for investors is that a bond with a lower credit quality comes with a higher risk of default. Default means a bond has missed an interest or principal payment.

So, how does this strategy work? Most importantly, investors must consider whether the potential benefit of receiving a higher interest rate is worth the higher risk of default. If this strategy is implemented, the fixed-income portion of a portfolio is oriented away from U.S. Treasury bonds and toward investments that increase credit spread risk. This category includes corporate bonds, mortgages, and high-yield investments. High-yield investments have lower credit ratings than investment-grade corporate bonds, although they typically offer higher yields.

These investments are a step out on the risk spectrum, but the risk is concentrated on credit spread risk. Corporate bonds, mortgages, and high-yield investments are typically driven by improving economic fundamentals. As a result, they could benefit from rising rate environments that see faster economic growth. Given the reasons for the recent inflation increase—namely reopening efforts and economic recovery—spread-oriented investments may make sense for some investors.

It’s important to note that corporate bonds, mortgages, and high-yield investments are not immune to the negative effect rising interest rates may have on prices. Nonetheless, the move from primarily interest rate-sensitive to spread-oriented investments could help lower the interest rate risk of a fixed income allocation. These investments could potentially provide a reasonable yield by shifting the risk exposure toward credit.

3) Consider Foreign Exposure

It might also be beneficial to shift a portion of your fixed income allocation to international bonds. Several factors can affect global interest rates, but the economic fundamentals for individual countries primarily drive their respective rates. Given the diverging global economic recovery, tactical opportunities may arise in developed and emerging international markets.

Including international bonds diversifies a bond portfolio away from U.S.-based interest rate risk. Accordingly, this strategy could help dampen price volatility for a fixed income allocation when interest rates are rising.

As with spread-oriented investments, this strategy involves some interest rate risk. Still, diversifying exposure to include foreign interest rate risk may help lower a portfolio’s overall volatility.

4) Employ Yield Curve Positioning

Another strategy to consider is focusing on holding a diversified portfolio of fixed income investments spread across the yield curve. What is the yield curve? A yield curve is a line that plots the interest rates (also known as the yield) of bonds having equal credit quality but different terms to maturity.

When analysts consider interest rate risk, most hypothetical scenarios envision an environment where rates shift in parallel across the yield curve. In reality, however, this scenario rarely happens.

The interest rates for bonds usually depend on whether it’s a short-term or long-term bond. Short-term bonds are generally more sensitive to changes in the Federal Reserve’s monetary policy. On the other hand, interest rates for a long-term bond are driven more by the outlook for long-term economic growth. Given this fact, holding a bond portfolio with a diversified range of maturity dates could help protect against changes in monetary policy that increase interest rates.

Bond laddering is a strategy that can help diversify interest rate risk exposure across the yield curve. Instead of buying bonds that are scheduled to come due during the same year, purchasing bonds that mature at staggered future dates should be considered. This can allow for more regular reinvestment of income and helps insulate a portfolio against yield changes in a certain segment of the market.

Need Additional Information?

For assistance in evaluating your options, please contact me. We’ll talk through these strategies for managing the potential outcomes and risk of your fixed income portfolio. 

Bonds are subject to availability and market conditions; some have call features that may affect income. Bond prices and yields are inversely related: when the price goes up, the yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity.

A bond ladder, depending on the types and amount of securities within the ladder, may not ensure adequate diversification of your investment portfolio. While diversification does not ensure a profit or guarantee against loss, a lack of diversification may result in heightened volatility of the value of your investment portfolio.

The main risks of international investing are currency fluctuations, differences in accounting methods; foreign taxation; economic, political or financial instability; lack of timely or reliable information; or unfavorable political or legal developments.

This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Investments are subject to risk, including the loss of principal. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Please contact your financial professional for more information specific to your situation.

Wise debt management is a key component of healthy and effective financial planning. Today, most people carry some amount of debt to finance a degree or buy a home or car. Other debts may be incurred out of necessity or as part of an investment plan. Whatever your reasons for taking on debt, you should understand the different types of debt and their risks. This knowledge will help you manage debt wisely as part of your overall financial plan.

Primary Types of Debt
The two primary types of debt are:

• Unsecured debt. Credit card balances and student loans are common types of unsecured debt. Typically (without considering pandemic-related relief), missing one or more of your monthly payments on unsecured debt could result in late fees, increased interest rates, damage to your credit score, and/or action by a collection agency. A delinquent borrower can also be sued by the lender.
• Secured debt. With secured debt, the lender has an interest in an asset, such as a home mortgage or car loan. In the event of default, the lender has a legal right to repossess its interest in the asset.

Risks to Consider

The distinction between unsecured and secured liabilities should not lead to conclusions about when debt is appropriate. Credit card balances and car loans, for example, are rarely part of a healthy financial plan, in part because assets acquired this way are subject to rapid depreciation. Furthermore, because unsecured debt is convenient, it can get out of control quickly. So, avoiding credit card debt and car loans is advisable unless you have a strict budget and the discipline to stick to it.

Other types of debt, such as mortgages and business loans, could increase your long-term net worth, provided the asset value increases or remains more valuable than the loan balance. In these cases, you have less risk of the debt getting out of control because secured loans can be fully satisfied by disposing of the secured asset. But the obvious downside is you could lose your home, car, or other valued asset. As a result, even if secured debt has lower interest rates and more favorable terms, you should carefully weigh the potential downsides before taking it on.

 How Much Debt Can You Afford?

With any type of loan, lenders decide what level of risk they will accept when making a lending decision. Factors they consider include credit history and the prospective borrower’s debt-to-income ratio. But the lender’s main concern is answering the question, “What is the maximum amount we can offer this borrower with the least likelihood they will default on the loan?”

It’s important to realize that a lender’s willingness to loan funds does not mean accepting the loan is prudent. When analyzing your ability to carry debt, consider your budget carefully and focus on the following:

Liquidity. If you suddenly lost your job, would you have enough cash to cover your current liabilities? It’s a good idea to maintain an emergency fund to cover three to six months of expenses. But don’t go overboard. Guard against keeping more than 120 percent of your six-month expense estimate in low-yielding investments. And don’t let more than 5 percent of your cash reserves sit in a noninterest-bearing checking account.

Current debt. Your total contractual monthly debt payments (i.e., minimum required payments) should come to no more than 36 percent of your monthly gross income. Your consumer debt—credit card balances, automobile loans and leases, and debt related to other lifestyle purchases—should amount to less than 10 percent of your monthly gross income. If your consumer debt ratio is 20 percent or more, avoid taking on additional debt.

Housing expenses. Generally, your monthly housing costs—including your mortgage or rent, home insurance, real estate taxes, association fees, and other required expenses—shouldn’t amount to more than 31 percent of your monthly gross income. If you’re shopping for a mortgage, keep in mind that lenders use their own formulas to calculate how much you can afford. These formulas may not work for your situation. For a mortgage insured by the Federal Housing Administration, your housing expenses and long-term debt should not exceed 43 percent of your monthly gross income.

Savings. Although the standard recommended savings rate is 10 percent of gross income, your guideline should depend on your age, goals, and stage of life. You should save more as you age, for example, and as retirement nears, you may need to ramp up your savings to 20–30 percent of your income. Direct deposits, automatic contributions to retirement accounts, and electronic transfers from checking accounts to savings accounts can help you make saving a habit.

 Debt Pay-Down Strategies

If you’re carrying debt that exceeds what’s normal for the average household, we can discuss strategies to pay it down as aggressively as is reasonable. Here are two approaches to consider:

• Snowball debt elimination. This involves identifying lowest-balance debts and targeting them for priority repayment while making only the minimum payment on other items of debt. Once the lowest balance is paid off, move on to paying down a new set of lowest-balance debts.
• Debt avalanche. This strategy advocates paying off debts with the highest interest rate first. This makes mathematical sense but requires discipline and the ability to stick with the process.

 Debt and Your Investment Plan
In some cases, you may believe that holding debt, such as a mortgage or margin investments, is beneficial. This idea is usually based on the potential for your investments to outperform the interest rate on the applicable loan and the investment opportunities you could explore with that extra liquidity.

For instance, you might believe that paying off a mortgage or margin loan could represent a tax-free return on investment essentially equal to the interest rate paid on the debt. But you would enjoy a significant net benefit only if the rate of return substantially exceeds the cost of the interest. And that result cannot be guaranteed. So, though this strategy could potentially yield a monetary benefit, the overall risk involved is significant.

 Need Additional Information?

We’ll talk through these strategies for managing debt and explore other planning solutions that can help you stay or get on track to financial security. By carefully approaching debt with a detailed plan on how much to borrow and how to repay your debt, you can reach your goals and support your long-term financial success.

© 2021 Commonwealth Financial Network^®

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer. Third party links are provided to you as a courtesy and are for informational purposes only. We make no representation as to the completeness or accuracy of information provided at these websites.

By Sarah Ruef-Lindquist, JD, CTFA
In 2022, retirement contribution limits for 401(k) and other types of defined contribution plans (403(b), 457 and Thrift Savings plans) will increase $1,000 to $20,500 for those under age 50, and for those 50 and older to $27,000.

This amount is $1,000 higher than it has been and is great news for retirement savers. Taking advantage of plans that allow taxpayers to make pre-tax contributions that then are treated as tax-deferred until withdrawn in retirement is a smart part of retirement planning.

Pre-tax contributions reduce your tax liability because the amount of the contribution is deducted from gross income. The retirement account is not taxed on any income or capital gain as long as funds remain in the IRA, with the exception of amounts withdrawn. Those are taxed as ordinary income. Taxes can be delayed to age 72, when annual minimum distributions are required to begin. Then income tax is due on withdrawals.

There is no change in the contribution limit for Individual Retirement Accounts (IRA’s). That amount remains at $6,000 for those under age 50, and $7,000 for those age 50 and older. The amount has not changed since 2019.

Other recent legislation allows people to continue to make contributions after age 70, as long as they have income of at least the amount of the contribution.

More workers may now qualify for Roth IRA contributions, based on income phaseouts that are rising $4,000 ($129,000 – $144,000) for single filers and rising $6,000 ($204,000 – $214,000) for married filing jointly.
Be sure to check with your tax preparer or financial advisor about how any changes in the laws regarding retirement savings and planning impact your particular situation.