Passed in December 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act included several provisions designed to address a wide variety of retirement planning topics. Considered one of the most comprehensive pieces of legislation affecting retirement savings, it contained several reforms designed to make saving for retirement simpler and more accessible for everyone.
The SECURE 2.0 Act was signed into law in late 2022, bringing several additional changes related to retirement and savings not included in the original legislation. These changes, too, were aimed at encouraging more workers to save for retirement. While not a comprehensive list, below are the takeaways we feel are the most noteworthy.
1. Required Minimum Distributions
To comply with IRS mandated tax rules, a required minimum distribution – often referred to as a “RMD” – is the amount that must be withdrawn from a qualified retirement account or IRA each year. The SECURE 2.0 Act raised the RMD age to 73, starting in 2023 and to 75, starting in 2033. Previously, the penalty for failing to satisfy the minimum distribution was 50% of the amount not taken. That penalty is now reduced down to 25%, and further to 10% if corrected within two years.
Roth 401(k)’s, unlike Roth IRA’s, are currently subject to the same RMD rules as traditional qualified retirement accounts. However, beginning in 2024, Roth 401(k)’s will no longer have minimum distribution requirements.
2. Retirement Plan “Catch Up” Contributions
Currently, individuals who have reached age 50 or older are permitted to make catch-up contributions into their employer sponsored retirement plan. The catch-up limit for 2023 is $7,500 and is indexed annually for inflation. Traditionally, plans offered the option to designate these contributions as pre-tax and/or after-tax Roth. Under SECURE 2.0, for participants with income over $145,000, all catch-up contributions need to be made to after-tax Roth accounts starting in 2024.
Additionally, beginning in 2025, the catch-up contribution limit for those aged 60-63 will increase to the greater of (1) $10,000 or (2) 150% of the standard catch-up contribution limit.
3. 529 Plan Withdrawals
It’s not uncommon for investors with 529 plans to have account balances remaining even after college expenses are paid in full. Under current law, a withdrawal for anything other than qualified education expenses may be subject to ordinary income tax and a 10% penalty.
SECURE 2.0 changed the rules surrounding 529 plan withdrawals, allowing owners to roll over excess balances from a 529 into a Roth IRA. The following guidelines must be meet for the rollover to be considered valid:
4. Automatic Enrollment
With fewer companies offering pension benefits, the responsibility to save for retirement largely falls on individual workers. Those that don’t contribute will find themselves falling behind.
Beginning in 2025, all 401(k) and 403(b) plans established on or after December 29th, 2022, will be required to automatically enroll their employees into those plans at a minimum contribution rate of 3%, but not more than 10%. The contributions must increase by 1% each subsequent year until the participant has a contribution rate of at least 10%, but not more than 15%. As an employee, you still have the option of changing your contribution rate or opting out of the plan altogether.
5. Retirement Plan Portability
Current law enables employers to initiate mandatory distributions from terminated employee’s retirement plans after a 30-60 day waiting period, without the owner’s consent. If no action is taken, and the balance is between $1,000 - $5,000, the account can be automatically rolled into an IRA. Accounts with less than $1,000 can be paid out by check. SECURE 2.0 permits plan service providers to offer plan “portability”, meaning that account balances, rather than being cashed out, will transfer to the employee’s new retirement plan automatically when they change jobs.
6. Emergency Savings
The emergency savings provisions in SECURE 2.0 are designed to make it easier for participants to set aside funds for unforeseen emergency expenses. Beginning in 2024, plans are now eligible to offer non-highly compensated employees the option of establishing an emergency savings account as part of their retirement plan. Contributions will be after-tax and capped at $2,500. Distributions can be taken anytime, and the first four withdrawals must be free from any fees.
In addition, employers may also offer a tax – and penalty free emergency withdrawal of up to $1,000 per year. Withdrawals taken under this provision must be repaid within three years.
7. Student Loan Match
Under current rules, an employer is only allowed to match a participant’s pre-tax deferral or after-tax contribution into their retirement plan. SECURE 2.0 allows employers to make matching contributions on behalf of employees making student loan payments, even if they are not contributing anything to the plan. Beginning in 2024, employers are authorized to match those loan repayment amounts.
To qualify for the match, the following guidelines must be met:
If you have any questions regarding the SECURE 2.0 Act, or what impact it may have on your financial plan, our team of advisors at Cairn Investment Group are available to assist. Contact us anytime for a complimentary consultation.
Greetings from the Northwest!
What a difference 12 weeks makes in the weather! We’ve got a great start to the summer this year, not having to suffer through the typical June downpours before a sudden seasonal shift to dry and hot; we’re already there and my lawn is suffering. Sometimes it’s nice to have simple problems like that. Our friends in California are getting some great weather, too, but still dealing with an immense amount of water leaking out of the mountains. On a recent drive down the back side of the Sierra Nevada, I was delayed several times by flooding over US 395, and those mountains were still covered in snow.
Every quarter I like to give a few thoughts on what I see as big picture issues that escape the casual viewer due to the “forest for the trees” effect, before handing things over to Patrick for his deeper dive into the current market conditions. Frankly, I’m having a tough time finding something to discuss this quarter, mainly because so much has not changed, and you deserve not to read my opinion for the third time on a topic! There are many macro issues in play, yet resolution for most has been slow.
So, instead, I’ll turn inward a bit. First, I’ll remind everyone of our upcoming move. We’ll be out of the current location at the end of the day on July 13, the end of this week, and up and running on Monday, July 17 at our new headquarter location in Vancouver. Meetings that week can be scheduled at either the Vancouver location, or at our branch office in Portland. Remember that the Portland office is available by appointment only.
Another exciting development is that Cairn can now manage your 401K and other employer sponsored retirement plans. If you have a desire for professional management of your retirement assets, let us know and we can discuss how this works and what advantages this may bring to your financial outlook.
Finally, I’ll mention our expanding focus on financial planning. It’s something we’ve always done on demand but was not originally a core feature of our business. Times change and so have we. We have two Certified Financial Planners (CFP®) on staff, and we utilize the most comprehensive planning software available, allowing us to provide accurate and informative projections that reveal the key decisions that you must make as you make your way through life. This service has no additional cost to you, so if you feel like now is the time, let us know.
With that I’ll hand things over to Patrick:
With all the noise surrounding the economy, interest rates, and inflation, one could be forgiven for thinking that equity markets would be suffering. Instead, the S&P 500 has experienced a stellar first half. We have written at length regarding valuations, and risks facing current equity markets, and our opinion has not changed as nothing in the data has meaningfully shifted. In fact, today’s environment is similar to the one we wrote about a couple years ago when US equity markets were being driven by a few select companies. The two charts below show 6-month return contributions for the S&P 500 going back to 1991, and the year-to-date returns of some broadly followed indexes. Leadership has never been so narrow as it is right now, which is not the hallmark of a healthy market.
The top 10 stocks in the S&P 500 now make up over 30% of the index compared to 17% in 2015. Investors throwing money into this bloated index are making a huge bet that market dynamics are forever changed. Enthusiasm for the most popular stocks is also evident in sentiment indicators, with both the CNN Fear & Greed Index and Sentimentrader’s Smart Money showing extreme optimism.
This type of frothy sentiment has historically been a contrarian indicator when combined with high valuations. Outside of late 2021 and the tech crisis, valuations have never been higher.
The silver lining in this challenging environment is the fact that we are still finding some attractive companies and asset classes that present compelling long-term value. And as the interest rate environment has shifted over the last 15 months, we are able to earn a return on cash while we patiently wait for a more attractive investment environment. Thank you for your continued trust. Please reach out to me if you have any questions or want to discuss any topic in more detail.
Thanks, Patrick! With that, I’ll wish you all a wonderful summer full of family and travel.
Tim Mosier, President,
Cairn Investment Group, Inc.
Greetings from the Northwest!
I’ve heard that it’s finally Spring. I’d like to see some evidence before I believe it! All of us on the West Coast would welcome a change from the cold and rain. Attempting just that, I recently spent a few days at Disneyland with my granddaughters and rarely have I been so wet, and that’s from the perspective of a Northwesterner. I’m glad to be back in the dry, warm office.
Speaking of the office, Cairn continues to grow! I’m happy to announce that Dan Poe, recently of Ameriprise, has joined us an Investment Advisor in Portland. His bio will be up soon on our website. With Dan, we’ll have four Advisors with the firm, and be better able to serve the diverse needs of our clients. I’m really looking forward to having his help in answering your many questions and making sure that our investment strategy is in sync with your needs. While the world roils around us, we feel that it’s vital to make these investments in people to assure our future.
It’s been an interesting first quarter for 2023. While much has changed, like finding out that some big banks weren’t really solvent, much has not changed so much. Fundamentally, we’re still in a time of higher inflation, rising interest rates, and resilient employment. The same political and economic issues are being fought about in Washington. The major market indices are near historic highs, measured as either price or valuation. Since we have little exposure to the banking sector, and none at all to the banks considered at risk, our general outlook and plans remain steady. I’m sure that Patrick will expand on this.
The recent bank implosions are worth discussing briefly, because they caused disruption in the financial markets, and many of you have been concerned about the safety of your money. Banks fail when the FDIC says they fail. Sometimes it seems unfair and too preemptive, but everyone in that game knows the rules. Insufficient liquidity, the inability to meet depositors’ withdrawal needs, is the measuring stick. You can get there by facing too many withdrawals too quickly, or by making poor investment choices. They usually find a way of coinciding. The failed banks all played a part in their own demise by poor investment management relative to their obligations to depositors, and also by being a bit too successful at winning jumbo-sized clients who can demand huge withdrawals in a flash, which they did. The vast majority of banks do not have these issues, and the largest, considered too big to fail, get easy liquidity from the US government as they need it. While 90% of bank deposits are FDIC insured across the country, Silicon Valley Bank operated with about 10% of its deposits insured. So hopefully, on that topic, we can relax a bit and realize it’s just part of the process of burning off excesses from our long bull market.
At the height of the scare, the list of at-risk banks seemed to explode, and even included Schwab for a while. The metrics being cited were very one-dimensional and failed to recognize how well Schwab had consistently met the FDIC’s liquidity requirements, and how many billions of dollars Schwab has in reserve through the totality of its business. The company thought to be somewhat at risk, Schwab Bank, is just part of the overall Charles Schwab & Co., which includes the security broker dealer that custodies your assets. Only your Bank Deposit funds, also known as “sweep” funds, are connected to the Schwab Bank. These are insured up to $250,000 by the FDIC per account beneficiary. Schwab’s typical client has several types of accounts and is focused on overall wealth management much more than on banking. Almost half of these assets are managed by an advisor like Cairn, adding a layer of care and commitment that is unlike a typical bank. There is a nicely written piece on the Schwab website, in case you want to see some greater details on this. If you need to know more about this, just give us a call.
Let’s see what Patrick has to say.
All the turmoil in the banking sector, to date, has not rattled capital markets, with Large Cap stocks returning 7.50%, small cap 2.74%, international stocks 8.47% and bonds 2.96%. Headlines surrounding what the Fed might or might not do regarding interest rate hikes, combined with cracks materializing across regional banks, made for lots of volatility. At the end of the day, investors’ risk appetites remained strong despite these headwinds. There has been quite a bit written in the financial news about what has unfolded across the regional bank landscape. I won’t bore you with the small details, but the failure of Silicon Valley Bank was a byproduct of the Fed leaving interest rates artificially low for TOO long, not that the Fed started raising interest rates aggressively. Once interest rates, rightfully, started to rise, banks that had taken on too much risk investing in longer dated bonds exposed their balance sheet and solvency to risks most investors didn’t see coming. When deposit rates are close to zero, while T-Bills and money markets yield north of 4%, it can expose risks for banks that had invested customer deposits in long dated bonds.
Technological advances have allowed clients to move cash balances quickly, and at banks that focused their deposit base on large clients with balances above FDIC limits (SVB, First Republic, etc.), a bank run can happen. I applaud the FDIC for how they have handled the situation, to date. Stepping in swiftly and backing all deposits, regardless of FDIC insurance limits, while wiping out equity and debt holders, is how bank failures should work. As Tim mentioned, we have very little exposure to the banking sector, and that is a byproduct of our process and our investment discipline.
Over the last couple of years, I have mentioned that although valuations have been elevated for US stocks, one of the silver linings has been broad price participation. This means that returns were not being driven by a narrow list of names like markets witnessed from 2017 to early 2020. The chart below measures the S&P 500 equal weight v. the S&P 500.
We have seen a steep reversal in market participation this year. The reversal has been so sharp, as this chart from Tavi Costa of Crescast Capital shows, the largest 15 stocks in the S&P 500 have generated 100% of the returns to start the year.
The rebound in stocks to start the year has done nothing to alleviate the issue of lofty valuations for the S&P 500. Even with the index down close to 8% over the last year, valuations still sit at close to all-time highs. As a reminder, long-term returns, generated by stocks, are comprised of three variables: earnings growth, dividend yield, and change in valuation. To get to the 10% historical average return in US stocks that investors are beaten over the head with, you start with: earnings growth of 6% historically, plus a dividend yield of 2%, which puts you at 8%. To make up the 2% difference, multiple expansion needs to take place. Given that we are already sitting at historically high multiples, that seems to be unlikely. I would argue the path of least resistance is to have multiples contract, meaning that valuations will be a drag on returns for US stocks. It is just math.
The combination of high valuations, poor market participation, and a market that is still in a downtrend does not strike us as an environment where taking excessive risk will be rewarded. The bright side is that our investment universe is not limited to the S&P 500; and, being value managers, we are always focused on the price we are paying for an investment and whether that provides an adequate margin of safety before putting your capital at risk. We are still finding some attractively valued investments in US stocks, though the opportunities are limited. We find international equities to be more attractive and we look for opportunities to continue to add to that asset class when appropriate. Thank you for your continued trust. Please drop me a line if you want to discuss any topic in greater detail. —Patrick Mason
We are proud to announce that our own Patrick Mason has been selected as a panelist at the 2023 Private Wealth Pacific Northwest Forum being held in Portland on March 8, 2023.
The Private Wealth Pacific Northwest Forum was developed as an education-focused, in person event for allocators and asset managers. The purpose of this meeting is to facilitate the dissemination of actionable investor content, coupled with supporting the continued development of the private wealth investment industry in the Northwest region.
Patrick will have the opportunity to present his views on current and future market opportunities and strategies with other professional money managers.
Patrick Mason, Chief Investment Officer
Patrick is responsible for portfolio management, investment and economic analysis at Cairn Investment Group. He also plays a pivotal role in communicating Cairn’s investment philosophy to clients and prospects. His discerning and knowledgeable demeanor hallmarks any encounter with him. Patrick holds a degree in Economics, is a Certified Financial Planner, and a member of the CFA Society of Portland. He previously held portfolio management and financial planning positions with a local investment management firm, Charles Schwab, and TIAA-CREF prior to joining Cairn Investment Group during his investment career that began in 2002.
With the abundance of financial information now accessible online, the interest in Roth conversions has increased substantially in recent years, and for good reason. Roth IRAs are largely considered to be one of the most appealing retirement savings vehicles available. Coupled with declining tax rates and a proliferation of newly retired baby boomers – an estimated 29 million in 2020 – more and more people are left wondering, “Does a Roth conversion make sense for me?”
Roth conversions, unlike contributions, can be done by almost anyone. While the basics of a Roth conversion are understood by many, determining when, if, and how much to convert is often a complicated question to answer. Before deciding if a Roth conversion is right for you, it’s important first to understand the differences between the types of IRAs, the types of conversions, and the pros and cons.
TRADITIONAL IRAS VS. ROTH IRA
TYPES OF CONVERSIONS
Roth IRA Conversion
A Roth IRA conversion is the process of moving funds from a traditional, SEP, or Simple IRA – or a defined contribution plan like a 401(k) – into a Roth IRA. Anyone can convert eligible IRA assets to a Roth, regardless of income. Income tax is owed on the conversion in the year you convert. Assuming the contributions you made to the IRA account were deductible, you’ll owe income tax on every dollar. If the contributions were non-deductible, you’ll owe income tax only on your earnings. There’s no requirement on the amount of dollars you can convert each year, you can choose to do partial conversions of any amount.
Backdoor Roth Conversion
A backdoor Roth conversion is a strategy used by high-income earners to circumvent the income limits that apply to Roth IRA contributions. This strategy is possible because there are no income thresholds limiting who can make non-deductible traditional IRA contributions or Roth conversions. Whether or not you can make the maximum Roth IRA contribution annually depends on your tax filing status and modified adjusted gross income (MAGI). For ’23, as a single filer, you may contribute up to the annual limit if your MAGI is less than $153,000. As a joint filer, your MAGI must be less than $228,000 to contribute the maximum amount allowed. A backdoor Roth conversion is a process whereby you establish a traditional IRA account (or contribute to an existing account), make a non-deductible contribution, and then convert it to a Roth. Calculating the taxes on a back door conversion is further complicated by the pro-rata taxation rules. The pro-rata rule influences the taxation, calculating liability proportionally to the fraction of after-tax vs. before-tax contributions. Let’s look at two examples to help demonstrate the difference between these two circumstances.
Example 1: Paul earns over $228,000 per year as a joint filer, participates in his employers 401(k), and would like to make a Roth IRA contribution. Because his income is over the threshold, he cannot make a direct contribution. As an alternative he opens a Traditional IRA, makes a non-deductible contribution, and then converts those funds into a Roth IRA. Because his contribution was after-tax and non-deductible – and because he does not have other pre-tax IRA accounts – no taxes are due on the principal amount converted. Any earnings on the deposit would be subject to income tax at the time of conversion. If this is done is succession, earnings will be negligible.
Example 2 (pro-rate rule): Paul earns over $228,000 per year as a joint filer, participates in his employers 401(k), and would like to make a Roth IRA contribution but has a Traditional IRA that was funded with strictly deductible/pre-tax contributions. Again, because his income is over the threshold, he cannot make a direct contribution. He can, however, contribute to his existing Traditional IRA and then convert those funds to a Roth IRA. The tax consequences of this transaction will be much different because of the pro rata rule. The pro rata rule prevents you from converting only the after-tax funds, it must be proportionate to the fraction of pre vs. post tax contributions.
Let’s say Paul has a $100,000 Traditional IRA balance, $7,500 of which came from a non-deductible contribution (’23 maximum allowed for those over 50). If Paul chooses to convert the $7,500 contribution, he will need to calculate how much of the conversion will be subject to taxes; the steps are as follows:
Mega Backdoor Roth Conversion
A mega backdoor Roth conversion is a specific type of backdoor conversion where you contribute after-tax dollars to a 401(k) that you hold with your employer and then immediately roll those contributions into a Roth IRA or Roth 401(k). This strategy is only made possible if your companies plan document allows after-tax contributions and has an in-service withdrawal provision. For ’23, the pre-tax annual contribution limit for employer sponsored retirement plans is $22,500. Individuals above the age of 50 are eligible for a “catch-up” contribution, bringing the total to $30,000. However, if your plan allows after-tax contributions, the combined pre- and post-tax limit is much higher. In that instance, total employee and employer contributions of up to $66,000, or $73,500 for employees who are 50 or older, are allowed (for ’23). The after-tax dollars would then rollover, or convert, into a Roth IRA or Roth 401(k). The principal amount is not taxable; however, any earnings will be considered pre-tax and subject to taxation at the time of the conversion.
Example: Paul works for XYZ Co. and contributes to their 401(k) plan. XYZ Co’s plan documents allow after-tax contributions and In-Plan Roth conversions. To carry out the Mega backdoor Roth strategy, Paul must follow these three steps (see chart below for a detailed breakdown): (1) max out individual contributions to the 401(k), (2) make after-tax, non-Roth contributions up to the annual maximum (combined employee & employer), and (3) elect an in-plan Roth 401(k) conversion of the “remaining after-tax contribution allowed.” Alternatively, if the plan does not have a Roth 401(k) component, after-tax contributions can be moved into a Roth IRA, assuming plan the documents allow for in-service non-hardship withdrawals.
If you have met the five-year rule and are at least age 59 ½, Roth IRA withdrawals are completely tax-free. Tax-free withdrawals offer tremendous advantages in retirement, particularly in years when you have higher than normal income or want to realize capital gains without triggering additional tax liabilities.
Minimum Required Distributions
Unlike traditional IRAs, 401(k)’s etc., Roth IRAs do not have distribution requirements beginning at age 72. You can continue letting the funds grow tax-free for as long as you’d like. Minimum distributions can increase your income significantly later in life, especially when considering other means tested benefits, such as Medicare premiums and social security. The ability to leave Roth funds intact, without a withdrawal requirement, is a major advantage over other retirement vehicles.
Having a wide variety of account types in retirement provides you with the ability to pull funds in the most tax efficient manner possible. Maintaining diversity among IRAs, Roth IRAs, and Non-qualified (taxable), helps contribute to that efficiency.
Example: For tax year ’23, the marginal income tax brackets are as follows:
Paul, who is retired, has total taxable income of $89,450 filing jointly (after adjusting for deductions), putting him at the tail end of the 12% marginal income tax bracket. Any additional income he realizes this year, will put him in the 22% marginal income bracket. He has done a very good job of saving for retirement, but never contributed or converted funds to a Roth IRA. All of his retirement savings accumulated in 401(k) and traditional IRA accounts. Let’s say, for example, that Paul booked a vacation to spend some time with his family in Hawaii, at a total cost of $10,000. When he withdraws funds from the IRA to pay for the trip, he’ll pay tax on that distribution at a rate of 22%, nearly a 50% increase from his previous bracket. Because his only source of funds is IRA and 401(k) assets, he has no other option.
If he had Roth IRA and/or non-qualified taxable assets to withdraw from, he would have much more control over his tax liability. The option of pulling assets from those account types could have saved him $2,200 in additional federal income taxes ($10,000 * 22%). Maintaining a Roth IRA account in retirement can help prevent a situation like this.
Beneficiaries / Estate Planning
Roth IRAs are a particularly valuable estate planning tool. When inheriting a Roth, you are granted the same tax advantages as the original owner. Distributions are tax free, provided it’s been 5 years since the original account owner established the account (each conversion has its own 5-year requirement). The SECURE Act, which was passed in December 2019, changed the inherited IRA distribution rules. For those deaths that occurred in ’20 or later, non-spouse beneficiaries must establish an inherited Roth IRA account and withdraw the entire balance within a 10-year period or take a lump sum distribution.
The new law also created a category of beneficiaries called “eligible designated beneficiaries”, who are still permitted to stretch distributions over their life expectancy. As a non-spouse beneficiary, you must fall into one the of the following categories to qualify; (1) a minor child of the decedent (only applicable until the minor reaches the age of majority) (2) disabled persons (3) chronically ill (4) not more than 10 years younger than the deceased and (5) certain types of trusts.
Spousal beneficiaries can treat the account as their own, stretch distributions over their lifetime, deplete the account over a 10-year period or take a lump sum distribution.
Increases Ordinary Income
Any amount you choose to convert will increase your ordinary income, which may push you into a higher marginal tax bracket. Conversions only make sense if the converted funds are taxed at a rate that is lower than what you expect to pay in the future. Without proper planning, it’s possible to pay more lifetime taxes with a Roth conversion than without.
Conversions are Irrevocable
Many things can prompt your desire to reverse a conversion. Two of the more common reasons for doing so are: (1) poor investment performance and (2) underestimating your tax liability and/or marginal bracket.
Remember, the amount you convert from an IRA to a Roth IRA, under most circumstances, is fully taxable. If you perform a conversion and subsequently loose money on the investments, you may want to reverse that transaction, in hopes of reconverting when the account has a lower balance to reduce the overall tax liability.
Alternatively, you may underestimate your tax liability when planning for a conversion. Let’s say for example you convert $30,000 in October and then receive an unexpected bonus in December, pushing you into a higher marginal income tax bracket prior to year-end. Your total anticipated income, after receiving the bonus, may cause you to reconsider the prior conversion. Prior to 2018, you could have “recharacterized” the conversion, meaning you could move the converted funds back to the traditional IRA, eliminating taxes that would have otherwise been owed. Under current law, Roth conversions are irreversible. Once your conversion is complete, nothing can be done to reverse it.
Ordinary Income Tax Ripple Effect
It’s important to understand the interrelationship that exists between ordinary income, capital gains, social security and other taxes and surcharges; including net investment income tax and Medicare premium surcharges. Long-term capital gains stack on top of ordinary income, so an increase in ordinary income can trigger additional capital gains taxes. Ordinary income also plays a factor when calculating “provisional income,” which is used to determine how much, if any, of your social security benefit will be subject to tax. Lastly, more ordinary income can trigger Medicare premium surcharges and/or net investment income tax.
Beginning in ’07, government began reducing the subsidy for high-income individuals, causing them to pay higher monthly amounts for Part B and Part D Medicare premiums. These surcharges are referred to as “Income-Related Monthly Adjustment Amounts,” or IRMAA, which is determined by income on your tax return from two years prior. See the chart below for a breakdown of these surcharges based on income:
Net investment income tax is a 3.8% surtax paid in addition to regular income taxes. The surtax applies only if you have net investment income – capital gains and dividends, interest and annuity payments, passive business income and/or rents – and MAGI over a certain amount; $200,000 filing single and $250,000 filing jointly. The surtax applies to your net investment income or the portion of your MAGI that excess the threshold – whichever is less. For example, if you have $40,000 in net investment income and your MAGI goes over the threshold by $60,000, you’ll owe the 3.8% surtax. But you’ll owe only on the $40,000 since it’s the lower of the two amounts. Total tax would be $1,520 ($40,000 x 3.8%).
The rules and tax implications of converting any amount from a traditional IRA to a Roth IRA – or as a backdoor or mega backdoor conversion – are very complex. We strongly recommend you consult with a tax advisor and/or financial planning professional to help properly determine if a conversion is right for you before executing any of the strategies discussed herein.
The decision to convert to a Roth should be made in the context of a comprehensive financial plan. If you have additional questions or would like to explore any of these strategies further, our team of advisors at Cairn Investment Group are available to assist. Contact us anytime for a complimentary consultation.
Greetings from the Northwest!
It’s a new year, and, I hope, a happy one! I had to check the calendar to believe that it’s been three years now since I took the helm from Jim and began writing the opening lines of these newsletters, and what a three years it’s been! It’s a matter of fact that none of us truly knows what the future holds, but I must say, “How could I have known” that Covid would shut down the economy in just a matter of weeks, tanking the stock market with it, and that massive government aid and a taste for speculation would propel markets to new highs while the pandemic still raged?
In that first newsletter we were already expressing concern that markets were pricey and that risk-taking behavior was higher than warranted. Patrick shared the CNN Money Fear & Greed Index, with the indicator firmly planted in the “Extreme Greed” quadrant. I did not track that meter much over the next year, but it must have been quite dynamic as the events unfolded. As I write this, it is firmly in the “Fear” quadrant.
We know now, that in fact, many assets were overpriced, and some hard lessons were learned by those who chased performance or went all in on the “highflyers.” I’m glad that I never participated in the Crypto Craze and both Patrick and I gave consistent advice against it. That’s just a foundational part of who we are and how we think, rather than some precognition or other talent. Our beliefs and our processes have served us well as the market has deflated off its highs this year and will continue to provide a buffer against what may come.
Speaking of which, I see 2023 as a year of reckoning with number of issues, not all financial in nature. A new burst of economic growth is unlikely to happen until inflation is back to reasonable levels. We’ll all have to live with new higher interest rates and adapt our personal economic decisions around them. So too, our political leaders will need to grapple with this, as the cost of funding their unprecedented spending is no longer free. The war in Ukraine needs to get resolved in favor of Ukraine for many reasons; one is that the adoption of Ukraine into the European community and the rebuilding that will follow may well be “the thing” that launches our next recovery. The opposite outcome is too bleak to consider.
With that I’ll hand things over to Patrick for a more specific and detailed examination of your investment prospects.
What a difference a year makes. As Tim mentioned, at the start of 2022 investors were trumpeting the strong stock market returns and accommodative fiscal and monetary policy that 2021 witnessed. Although 2021 had ended well, we discussed in our 4th quarter letter that inflation pressures were starting to alter consumer sentiment, which could have a profound impact on corporate profits and valuations. Well, here we are a year later, and valuations have slightly improved, with the S&P 500 having fallen over 18%, whereas international stocks measured by the MSCI EAFE fared slightly better, declining by over 14%. Negative performance in the bond market is what caught most investors by surprise, with the Bloomberg US Aggregate declining more than 13%. Seeing both stocks and bonds decline at the same time is not something most investors are used to experiencing, leaving the unprepared asking, “Where can I hide?”
Thankfully, we at Cairn were prepared for what had transpired and were able to avoid many of the large drawdowns in stocks and bonds. Our disciplined process is built around finding unrecognized value in companies and asset classes, and then making sure we are compensated enough for the risks that could unfold. If we are not finding opportunities, we are more than willing to hold cash, which was one of the best performing asset classes in 2022! Many of you have expressed concerns in the past about holding cash, since interest rates were at very low levels. My response was always two-pronged: First, cash gives you instant optionality to do something different without having to sell something in your portfolio that you might not want to sell. Second, cash is the BEST short-term inflation hedge. As inflation and short-term rates start to rise, your cash rate adjusts and the nominal value of your cash does not go down, unlike stocks and bonds.
Many of the Covid darlings that rewarded investors in 2020 and 2021 saw their share prices drop by 50-80% in the last year as interest rates increased and concerns about future growth took center stage. We have discussed this many times in the past, that the price paid for an asset is the largest determiner of your future return. Growth investors learned this lesson in real time. The chart below shows the one-year price performance of four of the Covid darlings; Tesla, Netflix, Zoom Video, and Peloton Interactive.
Equal weight ownership of these companies would have produced a return of -64% in 2022. I have nothing against any of these four companies (I love my Peloton); I just use them as an example that large losses can be realized by paying too high a price for even disruptive and innovative companies. In fact, of these four companies, only Tesla has had a positive price performance over the last 3 years. Large losses destroy compounding much faster than the benefit of a large unrealized gain.
Our disciplined value philosophy also served us relatively well during 2022. I must admit, my patience was put to the test from 2014-2021 as value underperformed growth by a wide margin, prompting many headlines stating that value was dead. Though one year does not signal a complete shift in trend, I am happy to hear that argument going silent. As the chart below shows, value stocks have outperformed growth stocks by over 30% from their lows of November 2021. If history is any guide, we are still in the early stages of this outperformance, especially given the current inflation and interest rate backdrop.
Concerning inflation and interest rates, as we have said many times, we are not in the business of predicting the direction of inflation and interest rates but will observe where we are now to make decisions. Our view based on the current data is that inflation will continue to come down from its peak levels witnessed in the fall. Many pressures that caused the spike in inflation will inevitably roll off as the months go on. The Fed has stated that they intend to keep short-term rates higher than inflation for longer than what capital markets might expect. We will see. Historically, the Fed has changed their tune as soon as financial stress gets too painful. The strong performance of stocks during the 4th quarter seems to point to the “hope” that the Fed will have to reverse course sooner than later. But as a reminder, the Fed has never cut rates when inflation is above the Fed Funds Rate. And looking at the chart below, we still have a way to go.
As we enter a new year, our portfolio positioning remains defensive as risks are still tilted towards the downside. If we get a more material retreat in valuations or price behavior improves, we will be more than happy to put some of our excess cash to work. From an asset class perspective, we still have a positive intermediate term view on international stocks, though that was not materially helpful during 2022. With the strength in the US Dollar starting to subside, international equities could provide a nice tailwind in the future as valuations are much more attractive than broad US stocks. Thank you again for your continued trust and support. I’m always happy to discuss any of these topics in more detail, so drop me a line anytime. —Patrick Mason
Thank you, Patrick. You may have noticed that a smiling new face has been added to our team in the form of Stefanie Schneider. Hopefully, more of you will make it into the office as the season turns, and have a chance to introduce yourself. Remember, the coffee is always hot and free.
Tim Mosier, President
Cairn Investment Group, Inc.
It’s hard to believe we’re on the precipice of yet another new year but, here we are. Temperatures are dropping, family get-togethers are being organized and, pretty soon, coffee shops will be filled with the familiar echoes of holiday music. Before the hustle and bustle of the holiday season takes over entirely, it’s important to take a moment and make several year-end planning items a priority. Below is a checklist of eleven items you should examine, which can help secure your financial plan as we transition into the new year:
The U.S. tax system is complicated. Understanding the intricacies of the tax code and how different sources of income – including social security and capital gains – interact with one another can be intimidating, especially when transitioning into retirement. Our “Taxes in Retirement” webinar will address these topics and more while providing information on the tools available to help you proactively create tax-efficient strategies and avoid common tax pitfalls.
View the webinar here.
Greetings from the Northwest.
I can hardly believe that it’s been a year since I wrote of frosty mornings and fall colors! This year it’s summerlike temperatures, sunglasses, and tinder dry vegetation. I’m afraid that the eventual but certain surrender to Autumn may be more abrupt than usual.
It’s been a rough investing season so far. I’m not sure I know why the stock market likes to pick the fall to make its most dramatic downside moves, but if September is a gauge, we’re probably in for some more pain before the bargain shopping kicks into gear to turn things around. We’ve done much to protect your assets from the most painful moves, as Patrick will point out, and we’ll continue to look for opportunities to reduce risk or pick up a bargain when we can. For most of you, staying the course will yield the best result, but if your needs and circumstances have changed, please let us know so that we can re-evaluate our plan.
Here’s a topic that we’ve never really touched on before, and it has nothing to do with making you more money: In times like this it’s common to allow negative sentiment to seep into our decision making and knock us out of our normal patterns in many unexpected ways. While we’re all experiencing what’s likely a temporary reduction in our wealth, many of the organizations that provide for those in need, protect the environment, or otherwise do the hard work that most of us cannot do ourselves, still need our help, and they often find that getting the funds to do so is a bit tougher in times like this. I suggest that we continue to remember the causes that are dear to us, even when our own fortunes may be somewhat less.
With that, I’ll hand things over to Patrick, who will again school us on the numerical realities of investing.
It is understandable to hear investors’ comments about never having seen a market environment like the one we are living through now, having never witnessed both US stocks and bonds decline for 3 quarters in a row (h/t Liz Ann Sonders). High inflation, and the Fed’s response by raising interest rates at an unprecedented pace, have caused a shift in investor sentiment and risk-taking behavior across numerous asset classes. We have observed a quick reversal in how households and investors are feeling about their future, with the consumer expectations index hovering in recessionary territory.
Though households are feeling pessimistic about the future, it seems like most investors have been conditioned over the years to expect that the Fed will always have their back, so even though pessimism is high, it seems like a fake pessimism. Although we are still in a bear market, and households are as pessimistic about the current economic environment as they have been in 30 years, very few are acting like it. The chart below shows household allocations to stocks still sitting at close to 65%, which is much higher than previous bear market lows where consumer confidence currently sits.
So even though valuations have come down from their extremes (though still not cheap) and sentiment is low, the fact is that household allocations to stocks remain elevated, and we haven’t seen the signs of capitulation that signal that this bear market is over.
In our first quarter letter we suggested that TINA (There is No Alternative) might be a thing of the past, as interest rates were starting to move higher. I think market pundits are going to have to come up with a new acronym, now that interest rates have risen substantially this year. The chart below shows US treasury bond rates at the start of the year and what the corresponding rates are now. Needless to say, there are now compelling opportunities to earn interest in more conservative assets, which we have not seen since 2007. Another observation looking at this chart that has been caused by aggressive Fed policy is this: I don’t know how something doesn’t break with rates rising as quickly as they have across the entire yield curve. Treasury rates are the starting place for the pricing of many other financial products across capital markets (just look at the current 30-year mortgage rate of 6.70%). Time will tell if the Fed will/can remain so vigilant in fighting inflation if higher rates start to have more broad consequences across the economy and capital markets.
We have spoken many times over the years about the risks that have been present in markets due to high valuation combined with overly optimistic sentiment. We are not seeing those risks become a reality. We have preached risk management and protecting against the full brunt of market losses when bull market cycles inevitably turn. Though portfolios are down this year, holding extra cash and focusing on attractively valued companies and asset classes have helped us not participate in the full brunt of equity market losses. In our fixed income portfolios, we have focused on high quality, shorter maturity bonds which have also held up well compared to the broader fixed income market. Even though we are still cautious in thinking that the worst is behind us, we are now finding opportunities in companies and asset classes that were not present a year ago. Having extra cash in portfolios accomplishes two important goals during this period. First, it helps protect the portfolio when both stocks and bonds are not performing well. Second, it allows us to take advantage of opportunities without having to sell other assets that might be at depressed prices. So even though we still view risk as being elevated, we have the flexibility to shift gears when the time comes. We appreciate your continued trust and are always open to discuss any topic or concern in more detail if needed. —Patrick Mason
Thanks, Patrick. If any of this feels like it needs a better explanation, please give us a call.
Tim Mosier, President
Cairn Investment Group, Inc.
Greetings from the Northwest.
It looks like this year’s take on summer has arrived, and we’re seeing a noticeable surge in the number of people mingling, dining out, shopping, and pursuing their outdoor passions, despite the higher costs that have been lightening wallets. The basic human need to live our lives and move beyond the virus is driving this burst of social activity. We’ll see how long this can survive in the face of the higher prices we’re experiencing. I’m sure glad I don’t have air travel planned any time soon, as that appears to be an unpredictable and expensive mess.
So here we are, officially in a bear market, having just completed the worst first half experienced in our stock markets since the 1970s, with more clouds in the distance, as historically, the second half is the rougher. We’re probably in a recession, but a strange one. The economy is trying to burst forth from our COVID-induced lull, while at the same time the Fed is dousing the flames of the stimulus bonfire; and there’s a war and a lingering virus. The stock market has been overpriced for some time, so it’s not surprising to see a pull back, and Patrick will point out that overall, it’s still not cheap, despite some huge drawdowns in the more speculative asset classes. Housing is due for a correction of sorts, and it’s probably in the early stages of one.
Depending on who you talk to and where you get your news, you could get the impression that the sky is falling and that we’re in a complete and total market meltdown. To be sure, it has been tough to find shelter in this storm, but I find comfort in our process, imperfect as it may be, believing that we’ll come out of this better than the broader markets, and well prepped for whatever’s next. Your actual experiences will vary, but I believe that what you have seen so far with your investments is distinctly less frightening than the shrill alarms being heard on many media outlets.
On another, somewhat related note, I’m proud and excited to share with you that Cairn Investment Group was honored this last month as one of Oregon’s fastest growing private companies by the Portland Business Journal, the result of much hard work by the entire team.
With that, on to Patrick and some specific and useful thoughts:
Equity and fixed income markets continued their march lower during the 2nd quarter, as investors continued to absorb rising inflation, tighter monetary policy, corporate profit margin pressures, and still high equity valuations. There were very few places for investors to hide during the first half of the year as large cap stocks, measured by the S&P 500, are down -19.96% and the Bloomberg US Aggregate Bond Index down -10.35%. I pointed to this as a risk in our Q1 2021 letter:
As we’ve discussed with many of you during meetings and reviews, stocks are not a very good inflation hedge when they are combined with high valuations. It’s only after valuations return to a more reasonable level that stocks offer a good hedge against inflation. The actual best hedge (short-term) against inflation is cash, which is why we have been holding a higher-than-normal cash allocation in portfolios for the last 18 months. The chart below shows inflation (vertical scale) and valuations (horizontal scale). As it illustrates, generally when you have 8.5% inflation, valuations are much lower than where they currently stand. So even though valuations have fallen from their historical extremes that investors were witnessing to start the year, they are still well above normal given the current inflationary backdrop.
To combat the steady rise in inflationary pressures the economy has been experiencing, the Fed has become more aggressive in raising interest rates and tightening financial conditions. During their June meeting they raised the fed funds rate by 0.75% and have been hinting that another 0.75% hike might take place in July. As the chart below indicates, historically, when inflation is over 8% the fed funds rate is higher, not lower, than the inflation rate. So, if inflation stays high, then the fed has a way to go in raising rates.
The biggest argument that we hear about why the Fed should slow their pace of interest rate hikes is the problem with the toolkit the Fed has to cool inflation. The options available are useful in decreasing the demand side of the inflation, not the supply side. Lyn Alden, of Alden Investment Strategy, said it best in her most recent monthly newsletter:
By raising interest rates, the Fed is in essence trying to raise unemployment and cool consumer demand. These actions could slow inflation for a period of time but, unfortunately, the price paid might be an economy that goes into recession. We are not in the business of predicting recessions, but we do have to be aware of the environment we are in and manage through it appropriately. With that said, we have a hard time believing that if the Fed continues down its current path, a soft landing they are hoping for is the most likely outcome.
Through all the negativity there are some silver linings. Though the S&P 500 is down over 20% from its highs, many companies and asset classes have fared far worse. Many of the high-flying growth stocks that helped fuel the market bubble we were in, are now trading like beaten up value stocks. Overall, portfolios continue to hold higher than normal cash positions and are defensively positioned based on what the data is showing us. This provides us plenty of flexibility to change course when opportunities present themselves across the investment landscape. Combined with our cash allocation, we continue to hold a portfolio consisting of high quality, value-oriented stocks and bonds across asset classes that can weather market turbulence and provide the ability for capital appreciation, once the market environment eventually changes course. Thank you again for your continued trust and feel free to reach out to me to discuss any topics in greater detail. —Patrick Mason
Here’s a reminder that the office is open, the coffee is fresh and hot, so please, don’t be shy about requesting an appointment or giving us a ring.
Tim Mosier, President
Cairn Investment Group, Inc.