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Why Aren’t Interest Rates Going Up?

Interest Rates, Inflation, and Monetary Policy: Why aren’t U.S. interest rates going up?

Our topic today is interest rates, inflation, and monetary policy. The question we will attempt to answer is: When are interest rates in the United States finally going to rise?

 

Defensive Strategies Depress Returns

If you’re like most bond investors, you’ve been expecting interest rates to rise for over 2 years now. As a prudent investor, you’ve been holding the duration, or interest rate risk, of your portfolios shorter than usual to protect against falling prices when rates rise. Unfortunately, the result of your prudent behavior has been to underperform standard indexes such as the Barclays U.S. Aggregate Bond index. And if your portfolio is focused primarily on safe assets such as U.S. Treasuries, all but the longest maturity funds struggled to provide a return even modestly better than inflation.

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Source: http://news.morningstar.com/fund-category-returns/ and https://fred.stlouisfed.org
1Author’s calculations

While short-term rates have indeed risen with the Federal Reserve rate hike in December 2015, interest rates for Treasuries maturing in 10 years and beyond have actually fallen by an average of more than -0.50% over the past 3 years. Granted, this article was written the day after the British referendum to exit the European Union, which caused global stock markets to tumble and U.S. Treasury yields to fall. If we measure the change in yields as of June 23, 2016 when most experts expected the British to vote to remain in the E.U., long term interest rates have still fallen an average of -0.37% since January 2013.

Capture2Source: www.treasury.gov

In contrast to the lack of upward movement in nominal interest rates, real yields – nominal yields adjusted for inflation – have risen across all maturities in recent years, albeit from an extremely low starting point. As of January 2, 2013 real yields for 5-year Treasury bonds were nearly -1.50%, whereas by June 24, 2016 5-year real yields are only negative -0.50%. And if you were willing to invest for 20 or 30 years, you could earn the princely sum of approximately +0.35% to +0.75% real yield as of January 2013 and June 2016, respectively.

If we take a longer term perspective and look back 10 years, we observe an enviable real rate of approximately 2.5% across maturities from 5 years to 30 years! At today’s paltry real yields of less than 1%, it seems unsustainable to invest hard-earned funds for 5 years or more and barely keep up with inflation. Surely interest rates must return to more normal levels eventually.

But when will that long-awaited time finally arrive?

Building Blocks of Interest Rates

To gain some insight into the drivers of interest rates, let’s take a moment to review the building blocks using what I like to call my ‘interest rate birthday cake’.

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Theory would have us believe that the minimum return investors will accept is a modestly positive ‘real return’, historically between 1.0% and 2.5%. If you add a maturity term premium and inflation expectations to the real rate, the result is the ‘risk free’ rate of interest, which we typically consider the U.S. Treasury yield curve.

The average annual inflation rate from 2006 to 2016 was 1.93%¹, so we could expect the risk free rate of interest over that time period to be approximately 3% to 4.5%. And yet 10-year Treasury yields are currently hovering below 2%, while 30-year yields stand at approximately 2.5%. In fact, 10-year Treasury rates have been falling ever since the ‘taper tantrum’ in mid-2013 as the U.S. economy continues to struggle to sustain momentum after the financial crisis of 2008-2009.

¹Source: U.S. Bureau of Labor Statistics

 

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Let’s not forget the aggressive monetary policy actions of the Federal Reserve bank since the financial crisis. The unprecedented amount of monetary stimulus has long been expected to cause inflation, and yet the only result to date has been to keep the U.S. economy from stalling.

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Source: http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

Why Has Aggressive Monetary Policy Not Sparked Inflation?

In times past economists observed a fairly reliable relationship between ‘easy money’ and the ‘velocity of money’, or the amount of times a single dollar changes hands. It is the velocity of money that traditionally puts pressure on prices of goods and services.

But as bank lending standards and capital requirements remain strict, consumer debt levels low, and with the ‘shadow banking system’ taking the place of traditional lenders, the velocity of money has been on a steady decline. Consequently, the impact of monetary policy on the economy has diminished.

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So if yields on Treasury securities remain stagnant, where else can we look for pressure on interest rates? One answer is the market appetite for risk – what Keynesian economists term ‘animal spirits’. The layers of my ‘interest rate birthday cake’ related to market risk appetites are default risk, liquidity risk, call risk, and others.Capture8

The term ‘animal spirits’ is used to describe human emotions that drive consumer confidence. Rising consumer confidence can increase the general level of economic activity if individuals feel wealthier and purchase more goods and services. If consumer demand grows sufficiently, prices of goods and services will increase, as will the general level of interest rates.

Chasing Yield – Investors Look to Corporate Bonds

If we look to Treasury yields for the risk-free interest rate, corporate bond yields should reflect a risk-adjusted rate of interest for various levels of default risk. In recent years, investors with an appetite for risk had found opportunities in low-quality corporate bonds, only to be traumatized in late 2015 and early 2016 as the precipitous drop in oil and gas prices put extreme pressure on the profitability of the energy sector of the U.S. economy. Because the credit quality of many smaller oil and gas producers was below investment grade, the high-yield sector of the bond market was particularly hard hit.

Option-adjusted yield spreads for BBB-rated corporate bonds – the additional yield above the yield of a matched-maturity Treasury – averaged approximately 1.75% in 2006-2007, prior to the financial crisis. In 2015-2016, BBB spreads averaged 2.31%. It seems investors are being fairly compensated for default risk at the current level of yields, despite a rather bumpy ride along the way.

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Traditional Drivers of Inflation Are Absent

So with this understanding of the building blocks of interest rates, can we answer the question of why Treasury yields remain stubbornly at levels barely above inflation?

The answer lies in the middle block of the interest rate pyramid: inflation. More precisely, the market’s expectation for future levels of inflation.

As you may recall from your Econ 101 course in school (assuming our readers stayed awake during class!), inflation typically occurs when either, 1) input prices are rising, causing manufacturers and service providers to increase their finished goods prices to the extent possible, or 2) consumer demand for goods and services exceeds the current supply, enabling manufacturers and service providers to increase their prices.

Though employment and consumer sentiment in the U.S. have certainly improved since the financial crisis of 2008-2009, the persistent trend of lower employment participation is thought to dampen the impact of the current, nominally low, unemployment rate relative to previous economic cycles.

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Even though the recent drop in oil and gas prices has stabilized, these essential commodities remain at historically low levels enabling manufacturing, transportation, and leisure travel firms to keep prices low.

Capture11 Capture12

Source: futures.tradingcharts.com

So when are these competing forces going to settle out and the long-awaited inflation pressures manifest themselves? Not any time soon, if the forward inflation rate expectations published by the Federal Reserve Bank of St. Louis are any guide.

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If inflation pressures are indeed muted on both the supply and demand fronts, and risk appetites are being satisfied with the current level of yield spreads, it is difficult to see where inflation pressures, and therefore interest rate increases, are likely to arise in the near term.

And yet investors cannot endure miniscule real yields indefinitely. Surely there must be something else keeping interest rates low?

As Long as U.S. Treasury Bonds Remain a Safe Haven, Treasury Yields will Remain Low

The final piece in the interest rates puzzle comes from outside the ‘birthday cake’; in fact, outside the U.S. entirely. The final piece is the capital ‘flight to safety’ as international investors seek positive returns amid a global economic slowdown and negative interest rates elsewhere in the world.

Capture14Source: U.S. Bureau of Labor Statistics

Given the economic uncertainty caused by the British referendum to leave the European Union, and the dearth of alternative ‘safe haven’ investments, we should expect demand for U.S. securities to remain strong over the near term. Continuing demand for U.S. Treasuries, even at historically low yields, coupled with muted economic activity dampening inflation pressures, means U.S. interest rates can remain low for the foreseeable future.

Eventually, foreign economies should recover and demand for U.S. Treasury securities should fall, pushing yields up to more normal levels as global economic activity strengthens.

But as long as the U.S. is ‘the only game in town’, prudent investors can legitimately maintain the maturities of their portfolios near- to above the standard market index to capture a positive inflation and term premium while awaiting calmer global markets sometime in the intermediate future.

 

Marcia Clark is an Investment Advisor Representative of Warren Street Wealth Advisors, a Registered Investment Advisor. The information posted here represents her opinions and is not meant as personal or actionable advice to any individual, corporation, or other entity. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional.  Nothing in this commentary is a solicitation to buy, or sell, any securities, or an attempt to furnish personal investment advice. We may hold securities referenced in the blog and due to the static nature of content, those securities held may change over time and trades may be contrary to outdated posts.

Supranational_European_Bodies-en.svg

Brexit, Bremain, Blah, Blah, Blah…

Last week we watched our version of “The City” lose in Game 7 of the NBA Finals, after blowing a 3-1 lead in the series. This week we watch as London, aka, “The City” and the U.K. at large enter their own final referendum homestand on whether to leave or remain in the European Union. Whether the U.K. stays or leaves, most of this outcome will be short term noise, and will deliver little long term impact in our opinion. Similar to how Cleveland winning a championship has their town in hysterics right now, it still won’t change the fact that their rivers light on fire.

As the clock ticks down, most polls show a healthy balance of IN or OUT voting leading to a proverbial coin flip for the U.K referendum. Consult the odds makers or gambling experts and you’ll get a slightly more confident story for the U.K to remain in the European Union. Let’s see where the money is:

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Source: http://www.oddschecker.com/politics/british-politics/eu-referendum/

If the masses turn out to be asses in betting, which would not be a first, what ultimate impact would a “Brexit” have on the EU or U.K. as a whole? Your guess is as good as mine at this point. A successful “Brexit” vote would start a minimum two year process described in Article 50 of the Lisbon Treaty in which E.U. treaties would still apply as negotiations were carried out to determine how the exit is ultimately handled. Big takeaway here is we’re not dealing with a binary event where a switch is flipped and suddenly everything we know about the E.U. changes overnight.

One of the larger talking points we hear discussed is how the U.K. will lose the majority of existing trading agreements and will be on an economic island. This is simply just not true. Sure the U.K. will need to go back to the negotiation table but they’ll have ample opportunity to continue relationships with the common market via the European Economic Area, European Free Trade Area, and even other more regional trade groups. Here’s an example of how many tangled webs one can weave:

File:Supranational European Bodies-en.svg
Source: Wikipedia

One could argue, and it is our personal sentiment, that much of the market is already pricing in a “Brexit” discount. It appears that the consensus view is that the U.K. would bear the brunt of the near term pain from an exit. This risk premium can be viewed in the form of currency volatility of the British Pound relative to the Euro as of late, shrinking British equity premiums relative to Eurozone stocks, and last but not least higher relative interest rates that lead to increased debt servicing costs. The U.K. and Germany for example have similar public debt loads, but it costs the U.K. approximately an extra $33 billion a year to service its public debt load.

UKvGER Yields

Source: Haver Analytics, Ned Davis Research

Having seen that a “Brexit” discount may already be priced, whether it passes or not, we remain committed to our international holdings and will likely take any near term dip as an opportunity to buy into weakness. Ideally, a remain vote instills confidence in some of the countries on the E.U. periphery that are struggling with structural reform and the European Union as a whole can get back to trend level growth. Something we’ve been patiently waiting for now for years.

All in all, a small part of me will be sad to see the “Brexit” vote come and go, it was a welcome distraction from the impending circus of an election the United States is about to endure. On that note, my counsel remains the same, turn off the TV talking heads, spend time with those you love, grow your value in the workplace, and be a strong steward of your wealth. That’s what we’ll be doing.

 

Respectfully yours,
Blake Street, CFP®

abc-blocks

The A, B, C, & D of Medicare

The A, B, C, & D of Medicare
Breaking down the basics & what each part covers.
Provided by Joe Occhipinti

Whether your 65th birthday is on the horizon or decades away, you should understand the parts of Medicare – what they cover, and where they come from.

Parts A & B: Original Medicare. America created a national health insurance program for seniors in 1965 with two components. Part A is hospital insurance. It provides coverage for inpatient stays at medical facilities. It can also help cover the costs of hospice care, home health care, and nursing home care – but not for long, and only under certain parameters.¹

Seniors are frequently warned that Medicare will only pay for a maximum of 100 days of nursing home care (provided certain conditions are met). Part A is the part that does so. Under current rules, you pay $0 for days 1-20 of skilled nursing facility (SNF) care under Part A. During days 21-100, a $161 daily coinsurance payment may be required of you.²

If you stop receiving SNF care for 30 days, you need a new 3-day hospital stay to qualify for further nursing home care under Part A. If you can go 60 days in a row without SNF care, the clock resets: you are once again eligible for up to 100 days of SNF benefits via Part A.²

Part B is medical insurance and can help pick up some of the tab for physical therapy, physician services, expenses for durable medical equipment (scooters, wheelchairs), and other medical services such as lab tests and varieties of health screenings.¹

Part B isn’t free. You pay monthly premiums to get it and a yearly deductible (plus 20% of costs). The premiums vary according to the Medicare recipient’s income level; in 2016, most Medicare recipients are paying $121.80 a month for their Part B coverage. The current yearly deductible is $166. Some people automatically get Part B, but others have to sign up for it.³

Part C: Medicare Advantage plans. Insurance companies offer these Medicare-approved plans. Part C plans offer seniors all the benefits of Part A and Part B and more: many feature prescription drug coverage and vision and dental benefits. To enroll in a Part C plan, you need have Part A and Part B coverage in place. To keep up your Part C coverage, you must keep up your payment of Part B premiums as well as your Part C premiums.4

To say not all Part C plans are alike is an understatement. Provider networks, premiums, copays, coinsurance, and out-of-pocket spending limits can all vary widely, so shopping around is wise. During Medicare’s annual Open Enrollment Period (Oct. 15 – Dec. 7), seniors can choose to switch out of Original Medicare to a Part C plan or vice versa; although any such move is much wiser with a Medigap policy already in place.5

How does a Medigap plan differ from a Part C plan? Medigap plans (also called Medicare Supplement plans) emerged to address the gaps in Part A and Part B coverage. If you have Part A and Part B already in place, a Medigap policy can pick up some copayments, coinsurance, and deductibles for you. Some Medigap policies can even help you pay for medical care outside the United States. You have to pay Part B premiums in addition to Medigap plan premiums to keep a Medigap policy in effect. These plans no longer offer prescription drug coverage; in fact, they have been sold without drug coverage since 2006.6   

Part D: prescription drug plans. While Part C plans commonly offer prescription drug coverage, insurers also sell Part D plans as a standalone product to those with Original Medicare. As per Medigap and Part C coverage, you need to keep paying Part B premiums in addition to premiums for the drug plan to keep Part D coverage going.7

Every Part D plan has a formulary, a list of medications covered under the plan. Most Part D plans rank approved drugs into tiers by cost. The good news is that Medicare’s website will determine the best Part D plan for you. Go to medicare.gov/find-a-plan to start your search; enter your medications and the website will do the legwork for you.8

Part C & Part D plans are assigned ratings. Medicare annually rates these plans (one star being worst; five stars being best) according to member satisfaction, provider network(s), and quality of coverage. As you search for a plan at medicare.gov, you also have a chance to check out the rankings.9

  

Joe Occhipinti may be reached at 714.823.3328 or Joe@Warrenstreetwealth.com

www.warrenstreetwealth.com

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

Citations.

1 – mymedicarematters.org/coverage/parts-a-b/whats-covered/ [6/13/16]
2 – medicare.gov/coverage/skilled-nursing-facility-care.html [6/13/16]
3 – medicare.gov/your-medicare-costs/part-b-costs/part-b-costs.html [6/13/16]
4 – tinyurl.com/hbll34m [6/13/16]
5 – medicare.gov/sign-up-change-plans/when-can-i-join-a-health-or-drug-plan/when-can-i-join-a-health-or-drug-plan.html#collapse-3192 [6/13/16]
6 – medicare.gov/supplement-other-insurance/medigap/whats-medigap.html [6/13/16]
7 – ehealthinsurance.com/medicare/part-d-cost [6/13/16]
8 – medicare.gov/part-d/coverage/part-d-coverage.html [6/13/16]
9 – medicare.gov/sign-up-change-plans/when-can-i-join-a-health-or-drug-plan/five-star-enrollment/5-star-enrollment-period.html [6/13/16]

 

QuestionDollars

What Are Catch-Up Contributions Really Worth?

What Are Catch-Up Contributions Really Worth?
What degree of difference could they make for you in retirement?
Provided by Joe Occhipinti

At a certain age, you are allowed to boost your yearly retirement account contributions. For example, you can direct an extra $1,000 per year into a Roth or traditional IRA starting in the year you turn 50.¹

Your initial reaction to that may be: “So what? What will an extra $1,000 a year in retirement savings really do for me?”

That reaction is understandable, but consider also that you can contribute an extra $6,000 a year to many workplace retirement plans starting at age 50. As you likely have both types of accounts, the opportunity to save and invest up to $7,000 a year more toward your retirement savings effort may elicit more enthusiasm.¹ ²

What could regular catch-up contributions from age 50-65 potentially do for you? They could result in an extra $1,000 a month in retirement income, according to the calculations of retirement plan giant Fidelity. To be specific, Fidelity says that an employee who contributes $24,000 instead of $18,000 annually to the typical employer-sponsored plan could see that kind of positive impact. ²

To put it another way, how would you like an extra $50,000 or $100,000 in retirement savings? Making regular catch-up contributions might help you bolster your retirement funds by that much – or more.  Plugging in some numbers provides a nice (albeit hypothetical) illustration.³

Even if you simply make $1,000 additional yearly contributions to a Roth or traditional IRA starting in the year you turn 50, those accumulated catch-ups will grow and compound to about $22,000 when you are 65 if the IRA yields just 4% annually. At an 8% annual return, you will be looking at about $30,000 extra for retirement. (Besides all this, a $1,000 catch-up contribution to a traditional IRA can also reduce your income tax bill by $1,000 for that year.)³   

If you direct $24,000 a year rather than $18,000 a year into one of the common workplace retirement plans starting at age 50, the math works out like this: you end up with about $131,000 in 15 years at a 4% annual return, and $182,000 by age 65 at an 8% annual return.³

If your financial situation allows you to max out catch-up contributions for both types of accounts, the effect may be profound indeed. Fifteen years of regular, maximum catch-up contributions to both an IRA and a workplace retirement plan would generate $153,000 by age 65 at a 4% annual yield, and $212,000 at an 8% annual yield.³

The more you earn, the greater your capacity to “catch up.” This may not be fair, but it is true.

Fidelity says its overall catch-up contribution participation rate is just 8%. The average account balance of employees 50 and older making catch-ups was $417,000, compared to $157,000 for employees who refrained. Vanguard, another major provider of employer-sponsored retirement plans, finds that 42% of workers aged 50 and older who earn more than $100,000 per year make catch-up contributions to its plans, compared with 16% of workers on the whole within that demographic.²

Even if you are hard-pressed to make or max out the catch-up each year, you may have a spouse who is able to make catch-ups. Perhaps one of you can make a full catch-up contribution when the other cannot, or perhaps you can make partial catch-ups together. In either case, you are still taking advantage of the catch-up rules.

Catch-up contributions should not be dismissed. They can be crucial if you are just starting to save for retirement in middle age or need to rebuild retirement savings at mid-life. Consider making them; they may make a significant difference for your savings effort.  

 

 

 

Joe Occhipinti may be reached at 714.823.3328 or Joe@warrenstreetwealth.com

 

www.warrenstreetwealth.com

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

Citations.
1 – nasdaq.com/article/retirement-savings-basics-sign-up-for-ira-roth-or-401k-cm627195 [11/30/15]
2 – time.com/money/4175048/401k-catch-up-contributions/ [1/11/16]
3 – marketwatch.com/story/you-can-make-a-lot-of-money-with-retirement-account-catch-up-contributions-2016-03-21 [3/21/16]

 

lightning-storm-clouds-wallpaper-3

Black April: The Twitch Partner Reckoning

April 2016 may have seemed like just another month on Twitch.tv, but the volume of Twitch partners struggling with the complexity of taxes on social media was louder than ever.

 

People are continuing to take their hobby of streaming video games and turning it into careers, many with great success. These successful careers are creating lives for many people that they haven’t experienced before, getting paid to do what they love. With this new found success and income came an increase in payments to the outstretched hand of the tax man, Uncle Sam. While for a majority of the people who have experienced this before, their thought may be: “Seems standard.” In this case, many who were impacted the most were not prepared for the impending tax bill and did not know what steps to take to soften the blow. Successful streamers in the past got away with standard tax preparations in their first year of business, but they did not anticipate the increase in the complexity of their taxes with the increase in their annual pay. This has always been a problem for those making a significant amount of money, a relatively new situation in the Twitch world.

 

Obviously, some may allude to the fact that tax preparation should be common knowledge. It’s hard to disagree with that statement, but many of these young entrepreneurs look at themselves as employees taking home a paycheck instead of as small business owners looking to manage their tax burden. Streamers who grew their respective gaming communities were thrust into a new position that some were not prepared for from a financial standpoint.

 

What is the glaring issue here? The main issue was the lack of knowledge on the streamer front as to how to handle taxes proactively. This was a first time experience for many, and for someone working under the 1099 independent contractor banner, it can be easily forgotten that taxes are a looming liability. The even more forgotten concern is the full 15.3% payroll tax that becomes the liability of the streamer versus only paying half as a W2 employee. If taxes are not adequately addressed in the current tax year, it can create years of future problems, additional payments, and more time spent dealing with the IRS.

 

The silver lining to this story is the viability of the interactive media market as a career for professional players, streamers, or content creators. This growing market is a breeding ground for sponsors to find new users of their products and create lifetime customers. Each micro-community on Twitch represents a unique opportunity for streamers to leverage their audience.

 

With taxes continuing to be an annual problem for streamers, there are solutions. Individual firms, consultants, and even pro-bono counseling groups are being formed for the sole purpose to better educate, prepare, and potentially offer professional services to those in need. One example is the Player Resource Center being developed by esports lawyer Bryce Blum and former professional gamer Stephen “Snoopeh” Ellis to fill this exact void. The growing interactive media environment needs professional infrastructure to help it continue to thrive into the future.

 

Outside of being able to generate a living via streaming, the biggest financial problem that streamers face is proper consideration towards taxes at the end of the year. With many firms looking to help and resources becoming available to those in need, there is hope that these entrepreneurs will continue to increase their efficiency and make the most of their success for years to come.

warrenstreetadvisors006
Joe Occhipinti
Joe@warrenstreetwealth.com
714.823.3328

downhousing-your-home

Should You Downsize for Retirement?

Some retirees save a great deal of money by doing so; others do not.
Provided by Joe Occhipinti

 

You want to retire, and you own a large home that is nearly or fully paid off. The kids are gone, but the upkeep costs haven’t fallen. Should you retire and keep your home? Or sell your home and retire? Maybe it’s time to downsize.

Lower housing expenses could put more cash in your pocket. If your home isn’t paid off yet, have you considered how much money is going toward the home loan? When you took out your mortgage, your lender likely wanted your monthly payment to amount to no more than 28% of your total gross income, or no more than 36% of your total monthly debt repayments. Those are pretty standard metrics in the mortgage industry.1

What percentage of your gross income are you devoting to your mortgage payments today? Even if your home loan is 15 or 20 years old, you still may be devoting a significant part of your gross income to it. When you move to a smaller home, your mortgage expenses may lessen (or disappear) and your cash flow may greatly increase.

You might even be able to buy a smaller home with cash (if finances permit) and cut your tax liability. Optionally, that smaller home could be in a state or region with lower income taxes and a lower cost of living.

You could capitalize on some home equity. Why not convert some home equity into retirement income? If you were forced into early retirement by some corporate downsizing, you might have a sudden and pressing need for retirement capital, another reason to sell that home you bought decades ago and head for a smaller one.

The lifestyle reasons to downsize (or not). Maybe your home is too much to keep up, or maybe you don’t want to climb stairs anymore. Maybe a condo or an over-55 community appeals to you. Maybe you want to be where it seldom snows.

On the other hand, you may want and need the familiarity of your current home and your immediate neighborhood (not to mention the friends close by).

Sometimes retirees underestimate the cost of downsizing. Even the logistics can be expensive. As Kiplinger notes, just packing up and moving a two-bedroom condominium’s worth of furniture will cost about $1,500 if you are resettling locally. If you are sending it across the country, the journey could take $5,000 or more. If you can’t sell or move everything, the excess may go into storage, and the price tag on that may be well over $100 a month. In selling your home, you will probably pay commissions to both your agent and the buyer’s agent that add up to 6% of the sale price.2

Some people want to retire and then sell their home, but it may be wiser to sell a home and then retire if the real estate market slows. If you sell sooner instead of later, you can always rent until you find a smaller house that could save you thousands (or tens of thousands) of dollars over time.

Run the numbers as accurately as you think you can before you make a move. Downsizing always seems to have a hidden cost or two, but for many retirees, it can open a door to long-term savings. Other seniors may find it cheaper to age in place.

 

Joe Occhipinti may be reached at 714.823.3328 or Joe@warrenstreetwealth.com.

www.WarrenStreetWealth.com

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

 

Citations.

1 – nerdwallet.com/blog/mortgages/two-ways-to-determine-how-much-house-you-can-afford/ [2/3/16]
2 – kiplinger.com/article/retirement/T010-C022-S002-downsizing-costs-add-up.html [4/1/16]

 

inherited-home-300x300

Explaining the Basis of Inherited Real Estate

What is cost basis? Stepped-up basis? How does the home sale tax exclusion work?
Provided by Joe Occhipinti

 

At some point in our lives, we may inherit a home or another form of real property. In such instances, we need to understand some of the jargon involving inherited real estate. What does “cost basis” mean? What is a “step-up?” What is the home sale tax exclusion, and what kind of tax break does it offer? Very few parents discuss these matters with their children before they pass away. Some prior knowledge of these terms may make things less confusing at a highly stressful time.

Cost basis is fairly easy to explain. It is the original purchase price of real estate plus certain expenses and fees incurred by the buyer, many of them detailed at closing. The purchase price is always the starting point for determining the cost basis; that is true whether the purchase is financed or all-cash. Title insurance costs, settlement fees, and property taxes owed by the seller that the buyer ends up paying can all become part of the cost basis (1).

At the buyer’s death, the cost basis of the property is “stepped up” to its current fair market value. This step-up can cut into the profits of inheritors should they elect to sell. On the other hand, it can also reduce any income tax liability stemming from the transaction (2).

Here is an illustration of stepped-up basis. Twenty years ago, Jane Smyth bought a home for $255,000. At purchase, the cost basis of the property was $260,000. Jane dies and her daughter Blair inherits the home. Its present fair market value is $459,000. That is Blair’s stepped-up basis. So if Blair sells the home and gets $470,000 for it, her complete taxable profit on the sale will be $11,000, not $210,000. If she sells the home for less than $459,000, she will take a loss; the loss will not be tax-deductible, as you cannot deduct a loss resulting from the sale of a personal residence (1).

The step-up can reflect more than just simple property appreciation through the years. In fact, many factors can adjust it over time, including negative ones. Basis can be adjusted upward by the costs of home improvements and home additions (and even related tax credits received by the homeowner), rebuilding costs following a disaster, legal fees linked to property ownership, and expenses of linking utility lines to a home. Basis can be adjusted downward by property and casualty insurance payouts, allowable depreciation that comes from renting out part of a home or using part of a residence as a place of business, and any other developments that amount to a return of cost for the property owner (1).

The Internal Revenue Code states that a step-up applies for real property “acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent.” In plain English, that means the new owner of the property is eligible for the step-up whether the deceased property owner had a will or not (2).

In a community property state, receipt of the step-up becomes a bit more complicated. If a married couple buys real estate in Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington, or Wisconsin, each spouse is automatically considered to have a 50% ownership interest in said real property. (Alaska offers spouses the option of a community property agreement.) If a child or other party inherits that 50% ownership interest, that inheritor is usually entitled to a step-up. If at least half of the real estate in question is included in the decedent’s gross estate, the surviving spouse is also eligible for a step-up on his or her 50% ownership interest. Alternately, the person inheriting the ownership interest may choose to value the property six months after the date of the previous owner’s death (or the date of disposition of the property, if disposition occurred first)(2,3).

In recent years, there has been talk in Washington of curtailing the step-up. So far, such notions have not advanced toward legislation (4).

What if a parent gifts real property to a child? The parent’s tax basis becomes the child’s tax basis. If the parent has owned that property for decades and the child cannot take advantage of the federal home sale tax exclusion, the capital gains tax could be enormous if the child sells the property (2).

Who qualifies for the home sale tax exclusion? If individuals or married couples want to sell an inherited home, they can qualify for this big federal tax break once they have used that home as their primary residence for two years out of the five years preceding the sale. Upon qualifying, a single taxpayer may exclude as much as $250,000 of gain from the sale, with $500,000 being the limit for married homeowners filing jointly. If the home’s cost basis receives a step-up, the gain from the sale may be small, but this is still a nice tax perk to have (5).

  

Joe Occhipinti may be reached at 714.823.3328 or Joe@warrenstreetwealth.com

www.warrenstreetwealth.com

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

Citations.

1 – nolo.com/legal-encyclopedia/determining-your-homes-tax-basis.html [3/30/16]
2 – realtytimes.com/consumeradvice/sellersadvice1/item/34913-20150513-inherited-property-understanding-the-stepped-up-basis [5/13/15]
3 – irs.gov/irm/part25/irm_25-018-001.html
4 – blogs.wsj.com/totalreturn/2015/01/20/the-value-of-the-step-up-on-inherited-assets/ [1/20/15]
5 – nolo.com/legal-encyclopedia/if-you-inherit-home-do-you-qualify-the-home-sale-tax-exclusion.html [3/31/16]

are-we-done-yet

Are We Done Yet?

February 12, 2016 by Marcia Clark, CFA

On January 26, 2015, I wrote an article questioning the relationship between falling oil prices, slowing Chinese GDP, and the precipitous decline in the U.S. stock markets. I counseled readers to take a breath, that the stock market turmoil was overdone and the U.S. economy was secure.

Shortly after my article, the S&P 500 index rebounded from 1903.63 to 1949.24 as on January 29th the Bureau of Economic Analysis announced 4th quarter GDP growth at a modest 0.7%, slightly below analyst expectations of 0.8%.

U.S. Real Gross Domestic Product and Civilian Unemployment Rate

 U.S. Real Gross Domestic Product and Civilian Unemployment Rate

Stock Markets Stabilize with 4th Quarter GDP Report

Why did the stock market react so well to such modest GDP growth? Perhaps because, if you look deeper into the GDP components, the slow growth was primarily due to weak exports and low oil prices, while consumer spending and residential construction remained strong. When considered in light of positive trends in disposable income and job growth, investors seemed fairly content with the 4th GDP results. Concern about specific sectors of the economy are well-founded, however, as low oil prices are indeed causing an increasing number of shale oil drillers to default on their debt obligations. But lenders prepare for this type of risk by diversifying their investments, and there is little evidence that distress in the oil patch will spread throughout the broader economy.

S&P 500 Stock Market Index, February 2015 – February 2016

S&P 500 Stock Market Index, February 2015 - February 2016

http://www.msn.com/en-us/money/indexdetails/fi-33.10.!SPX?ocid=INSFIST10

Do Stock Markets Really Predict Economic Recessions?

To twist a common phrase, every silver lining has a cloud, and in the days following the GDP announcement oil prices continued their downward trend and talk of an economic slowdown began to circulate in the financial press. By February 11, the S&P 500 index had plummeted to a low of 1829.08, before recovering a bit to end the week at 1864.78. Clearly, the turmoil was not over!

But does a falling stock market really foretell an economic decline in the U.S.? Let’s take another look at the evidence. The Brookings Institute published an article by George L. Perry on February 2, 2016[i] reviewing the relationship between stock market declines and economic recessions. Mr. Perry concludes that significant stock market declines – say 20% or so – do indeed tend to precede economic downturns. However, more moderate declines in the stock market happen much more frequently than do recessions. And when such declines are accompanied by decent economic figures, the predictive power of the stock market is unreliable.

In fact, the most recent Conference Board Leading Economic Index published January 22 shows a strong positive trend, despite the U.S. stock market being a component of the index. It’s important to note, however, that the index fell slightly in December due to weaker growth in housing and manufacturing. Also of note, the latest Leading Indicator Index does not include January’s stock market decline.

Leading Economic Index as of December 2015

Leading Economic Index as of December 2015

So, Where Do We Go From Here?

As articulated by Fed Chairman Janet Yellen in her testimony to Congress on February 11, the U.S. economy remains on an upward trend at present, though the future is uncertain. On the positive side, employment gains, low interest rates, and falling oil prices provide consumers with more disposable income to support domestic businesses. On the negative side, slowing Chinese and commodity-based economies, combined with the strong dollar, continue to depress U.S. exports.

On balance, I reiterate my earlier advice. CaptionStay strong, hold on tight, and wait for smoother sailing ahead. Investors with a tolerance for volatility might even consider buying into the distressed oil and gas sector.  Be warned, however! A risky endeavor such as this requires an abundance of fundamental analysis and healthy skepticism when forecasting future earnings. Such a venture is best left to the boldest among us with the ability to withstand the choppy voyage ahead.

 

Marcia K. Clark, CFA

Warren Street Wealth Advisors

Senior Research Analyst, Wealth Advisor

marcia@warrenstreetwealth.com

[i] http://www.brookings.edu/research/opinions/2016/02/02-stocks-and-the-economy-perry

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Turmoil in China, Oil, and the US Markets

Why is the turmoil in China and the drop in oil prices depressing the U.S. markets?

Marcia Clark, CFA, MBA, Senior Research Analyst & Wealth Advisor, Warren Street Wealth Advisors

January 25, 2016  10:43am Pacific time

In case you’ve been enjoying an extended holiday season, you may not realize that January 2016 is on track to become the worst January for the U.S. stock market since 2009. How worried should you be? Based on my analysis, my opinion is that the stock market has over-reacted to both the turmoil in the Chinese stock market and the drop in oil prices. Investments in companies other than oil producers, particularly those that benefit from cheaper oil prices, may deliver good results in the coming year.

S&P 500 February 1st, 2015 – January 2nd, 2016

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Source: http://www.bloomberg.com/quote/SPX:IND

And the bond market hasn’t been immune. Yields on below-investment grade bonds in particular spiked to levels not seen since 2012.

2

https://research.stlouisfed.org/fred2/series/BAMLH0A0HYM2

But why have the U.S. markets reacted so strongly to the Chinese market and oil prices? Has the U.S. economy encountered an unexpected pothole? Have an excessive amount of U.S. businesses or homeowners declared bankruptcy? Have scandals erupted in key corporations? Has the U.S. Congress threatened to shut down the government rather than pass a budget? No, none of these things has happened. Yes, industrial production and corporate profits have hit a bit of a slump. But the U.S. job market – probably the best indicator of imminent recession – continues to rebound with 292,000 new jobs in December and 2.7 million new jobs for the past year, according to the Bureau of Labor Statistics.

5

http://data.bls.gov/timeseries/CES0000000001?output_view=net_1mth

To recap the past few months in the Chinese stock market, as reported by The Economist (January 25, 2016), in early July 2015 China’s stock market crashed with share prices dropping by a third, wiping out some $3.5 trillion in wealth (more than the total value of India’s stock market).

6

A further plunge on August 24 followed by a fall of similar proportions the next day sent share prices down over 40% below their 2015 peak.

Since the summer, the Chinese stock market had rebounded approximately 20%, so one hoped that the worst was over. Unfortunately, on January 4th and again on January 7th the CSI 300 index of ‘blue chip’ Chinese stocks fell approximately 7% and fears of a serious economic decline were renewed.

Given that that Chinese stock market has indeed experienced a challenging 6 months, how can we extrapolate the severity of the problem to U.S. investors? Ultimately, the value of any stock market should reflect the profitability of domestic businesses.

On January 19th, China reported its official annual GDP growth figure for 2015 at 6.9%, just a shade lower than 2014’s 7.3%, and much stronger than average global forecast GDP of 2.8%, reported by the Conference Board.org in November 2015.

3

The worry seems to be that the official GDP figure may be manipulated by the Chinese government and that much worse lies ahead.

But how much of the decline in the Chinese economy should legitimately be reflected in the U.S. economy? It is difficult to calculate a precise figure, but for context see the table below.

Country Exports Imports Total Trade Percent of Total
China 106.1 443.9 549.9 16.0%
Canada 259.0 271.6 530.6 15.4%
Mexico 217.8 271.6 489.4 14.2%
Japan 57.7 119.8 177.5 5.1%
Germany 45.9 113.4 159.3 4.6%
South Korea 40.1 66.4 106.5 3.1%
United Kingdom 52.0 53.7 105.7 3.1%
France 27.6 43.7 71.3 2.1%
India 20.0 41.7 61.7 1.8%
Taiwan 24.0 37.5 61.5 1.8%

https://www.census.gov/foreign-trade/statistics/highlights/top/top1511yr.html

As of November 2015, China was indeed the largest trade partner with the U.S., so changes in their economy could definitely impact ours. However, note that exports – which bring profits to U.S. businesses – are much smaller than imports. This should buffer the impact of the Chinese decline somewhat. So troubles in the Chinese economy can indeed impact the U.S., though by how much is very difficult to say.

But what about falling oil prices?

As an input to so much of what we consume, lower oil prices depress final goods prices – including gasoline – which leaves more money in consumers’ pocket to buy other things. Yes, a severe drop in oil prices driven by a lack of demand would definitely indicate a recession, but that’s not what’s happening these past months. The problem is an overabundance of supply.

With the widespread use of hydraulic fracturing in the U.S., crude oil production in the U.S. has spiked to levels not seen in the last 30 years. With OPEC countries maintaining production near historic levels, and global demand growth increasing only modestly, basic laws of economics indicate that the market price of oil must fall.

7

https://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=WCRFPUS2&f=4

8

9

 

So where does that leave us? Yes, we should be concerned about the market turmoil in China as that country adjusts to a slower, but still strong, growth rate of their economy. Declining oil prices caused by excess supply is a good thing for consumers, but will depress profits of oil producers which can be a large component of stock market indexes.

On balance, the U.S. economy remains on an upward trajectory. Recent declines in the stock market should be viewed as a buying opportunity. But be selective! Companies whose revenues are strongly tied to the price of oil may continue to struggle until supply and demand reach a new equilibrium.