Q4 2020 Returns By Asset Class

This post contains the usual returns by asset class for this past quarter (by representative ETF), as well as year-to-date, last twelve months, last five years, and since the financial crisis lows of 3/9/2009.  While there is still no predictive power in this data, I’ll continue to post this quarterly for those of you that are interested. 

Q4 2020 (10/1/20 – 12/31/20)
Last 12 Month (1/1/20 – 12/31/20)
Last 5 Years (1/1/16 – 12/31/20)
Since ’09 Bottom (3/9/09 – 12/31/20)

A few notes:

  • While US Large Cap Stocks (S&P 500) had a fantastic quarter in Q4 (+12%), Foreign Stocks, both Developed and Emerging, actually outperformed (+16-17%), and US Small Cap Stocks completely dominated (+27%), finally playing a bit of catch up and topping their all-time high set back in 2018. All major asset classes were positive for the quarter. This was a quarter where many who try to market-time suggested caution was needed given a second wave of covid, a US election that could have dire consequences, gridlock and lack of stimulus from Congress, and a climax to BrExit. Trying to time the stock market and believing you’re smarter than all other investors, in aggregate, is a fool’s game. Q4 2020 is just another example.
  • Along those same lines, just look at 2020 performance as a whole. The worst pandemic in a century and stocks end the year strongly positive almost across the board (only REITs were negative as a major asset class).
  • On the 5-year chart, we can see that even commodities have now eked out positive returns, after being down almost 25% in March of this year due to covid. It’s been a rough decade for commodities, especially energy with supply glut after supply glut, followed by a pandemic-induced bout of demand destruction. Perhaps zero interest rates are starting a new uptrend here. There’s till a lot of oil and gas out there though, so it would be difficult for a rise in energy prices to not be met with more supply coming online fairly quickly.

Dec 2020 COVID Relief

This one hasn’t gotten a fancy name yet (that I know of) like the CARES Act since it is attached to the 2021 Consolidated Appropriations Act (the “2021 spending bill” that funds the government), so I’m just referring to it as the Dec 2020 COVID Relief Bill. It was signed into law on 12/27/2020 and consists of ~$900B of funding, not to be confused with the $1.4T in general “keep the lights on” type funding in the rest of the Act. The full Consolidated Appropriations Act is 5,593 pages. I cannot claim to have read the whole thing. However, I’ve skimmed through it and read enough summaries now to feel comfortable calling out the top line virus-related items and the key tax and personal financial planning items for you. This list below includes the COVID Relief Bill portions, the relevant tax and financial planning-related items from the rest of the Act, and a few other callouts. Here goes:

  • Direct Payments (“stimulus checks”) – ~$170B for direct payments to taxpayers. $600 per individual earning $75k or less, or $1200 per couple earning $150k or less, +$600 per dependent child under age 17 (e.g. $2400 for a family of 4 earning $150k or less). Above the $75k/150k threshold, the payment amount drops by $5 for every $100 of income until it is completely phased out. Income used is the lower of 2019 or 2020. Payments will be sent out by direct deposit or check based on 2019 income, but can be trued up on the 2020 tax return if income was lower or more children were born. For more details, see this fantastic article from Forbes, and this nifty chart from the Tax Foundation
  • Unemployment Benefits – $120B. extends emergency Federally funded benefits (including that for self-employed) for 11 weeks and provides a $300/week Federal amount in addition to existing state-provided benefits.
  • Paycheck Protection Program (“PPP”) – $284B extends PPP v 1.0 and issues a new round of funding for PPP v2.0 Additionally, reverses the IRS interpretation that business expenses used to qualify for PPP forgiveness were not deductible. They clarified that those expenses are deductible. It also broadens the list of qualifying expenses for forgiveness to include operating expenses, supplier costs, property damage costs, and PPE expenses, still subject to the limitation that non-payroll expenses cannot exceed 40% of the forgiven loan amount. Not exactly auto-forgiveness for small loans (many were calling for this), but the Act does tell SBA to create a one-page form to apply for auto-forgiveness (*smacks my head*) for loans < $150k. Side note: Auto-forgiveness = Ease of use as the main course, but with a large side of increased fraud. I think this auto-forgiveness means that an applicant would get forgiveness even if payroll was reduced during the covered period, so long as the PPP money wasn’t used improperly and no fraud was involved. PPP v 2.0 is for businesses w/ < 300 employees (<500 if accommodation or food service) and that had at least one quarter of 2020 with revenue at least 25% lower than the same quarter in 2019. Max loan is $2M or 2.5x avg monthly payroll whichever is less, (3.5x for accommodation or food service).
  • Vaccines, Testing, Health – $63 billion for vaccine distribution, testing and tracing, and other health-care initiatives, most of which will be administered by the states.
  • Transportation – $45 billion for transit agencies, airlines ($15B specifically allocated for airline payroll support), airports, state departments of transportation, and rail service.
  • Education & Childcare & Broadband Support – $82B in funding for colleges and schools, including support for HVAC upgrades to mitigate virus transmission + $10 billion for child care assistance + $7B for enhanced broadband access.
  • Nutrition & Agriculture – $26B for food stamps, food banks, school/daycare feeding programs, and payments, purchases, and loans to farmers and ranchers impacted by covid-related losses.
  • Rental Assistance – the eviction moratorium is extended through 1/31/2021 (for now). $25B is authorized to help troubled renters and landlords by paying future rent and utilities as well as back rent owed or existing utility bills.
  • SBA Loan Relief – The CARES Act authorized SBA to pay up to six months of principal and interest on existing Section 7 SBA Loans for impacted borrowers. This Act extends that by another three months.
  • Economic Injury Disaster Loans (EIDL) – $20B in additional funding for businesses in low-income communities + $15B of dedicated funding is set aside for live venues, independent movie theatres, and cultural institutions.
  • Credit for Paid Sick + Family Leave – this was created by the Families First Act and is now extended through 3/31/2021 (was 12/31/2020).
  • Employee Retention Tax Credit – created under the CARES Act, is extended through 6/30/2021 and improved. It’s now up to 70% of wages capped at $10k of wages per employee per quarter, instead of 50% capped at $10k in total. Business qualifies if revenue for the quarter was down at least 20% from the same quarter in 2019. Important: it appears this credit is now allowed along with a PPP Loan (under the CARES Act, it was one or the other), though you still can’t double count the same wages for the credit and PPP forgiveness.
  • Payroll Tax Deferral – the president signed an executive order in September allowing employers to opt in to a payroll tax deferral for employees. Almost no one did (except the government) because it was too risky on the employer and deferral for a few months was pretty meaningless. Those that did were supposed to repay the deferral by 4/30/2021. That has now been extended to 12/31/2021, giving more time to spread out the payback.
  • Lookback for Earned Income Tax Credit and Refundable Child Care Credit – taxpayers can, but don’t have to, use 2019 income instead of 2020 income to qualify for these in 2020.
  • Residential Solar Tax Credit – this was reduced to 26% of the cost of the project in 2020, scheduled to drop to 22% in 2021, and then eliminated after 2021. The Act extends the 26% credit for 2021 and 2022, dropping to 22% for 2023. It is now eliminated in 2024, unless additional legislation is passed.
  • Employer Paid Student Loans – Employers can continue to give up to $5250 per year tax-free to employees for student loan principal and interest repayment (either direct to the loan or to the employee to pay the loan). This is extended through 2025 (was set to expire at the end of 2020).
  • Tuition Deduction / Lifetime Learning Credit – The tuition deduction, unless extended in other legislation, is gone. Instead, there is now a higher income threshold for the Lifetime Learning Credit, now sync’d up with the American Opportunity Credit phaseout ($80-90k single / $160-180k married).
  • Student Loan Payment Forbearance – this WAS NOT extended in the Act. Student loan payments resume 1/1/2021.
  • Retirement Plan Distributions / Loans – The CARES Act allowed up to $100k of distributions from retirement plans for covid-impacted individuals, waiving the 10% penalty, and allowing the amounts to be repaid over 3 years such that no net tax would be owed. It also raised the 401k loan amount to the minimum of $100k or 100% of the balance (from $50k or 50%). These were effective through 12/30/2020. This treatment is now extended to non-covid-related Federally declared disaster areas between 1/1/2020 and 2/25/2021 where the individual has their principal place of residence and is economically impacted by the disaster.
  • Retirement Plan Required Minimum Distributions – these were waived by the CARES Act for 2020. This WAS NOT extended by the new Act. RMDs will be required for 2021 unless additional legislation is passed.
  • Medical Expenses Deduction – the deduction for medical expenses has been bouncing back and forth between a 7.5% AGI floor and a 10% AGI floor for years. It’s 7.5% for 2020 and was supposed to revert back to 10% for 2021. The Act sets this to 7.5% PERMANENTLY. One thing I can stop writing about every year!
  • Mortgage insurance premiums – remain deductible for another year through 2021.
  • The taxability of forgiven housing debt (foreclosure/short-sale) – is extended to 2025, but the amount is reduced to $375k single / $750k married.
  • Charitable Giving – The $300 charitable contribution deduction for those who don’t itemize is sticking around for 2021 now and joint filers will get $600 instead of $300 for 2021. Remember this is for cash donations only and donations to a Donor Advised Fund don’t count. And, the cap on the portion of your income you can give via a cash donation (other than to a Donor Advised Fund) and deduct stays at 100% for 2021.
  • Healthcare & Dependent Care Flexible Spending Account (FSA) flexibility – The Act allows plans to allow 2020 unused amounts can carryover to 2021 and 2021 can carryover to 2022. Additionally, the Act allows 2021 elections to be modified even though benefits enrollment is now closed for most employees. However, this only updates what the law will allow employer plans to do. The plans themselves would have to adopt the change in order for employees to be able to use the increased flexibility. Check with your benefits rep to see if your plan is adopting / has adopted the change.
  • Educator’s Deduction – this is the $250 per year that teachers get to deduct for money spent on school supplies for their classrooms (as if that’s all teacher’s spend on their classrooms). PPE and cleaning supplies now qualify for that $250.
  • Business Meals – for business owners, restaurant meals are 100% deductible for 2021 and 2022 (formerly only 50% deductible) as long as they meet the requirements of the previous 50% deduction (i.e. non-lavish, taxpayer is present, etc.). Note that this still does not include employee expenses, only schedule C filers. Applies to dine-in or take-out.
  • Surprise Billing Fix – an attempt to reduce the amount of “surprise billing”, which typically occurs when a patient goes to an in-network facility and uses an in-network doctor, but is provided services by an out-of-network provider along the way (e.g. anesthesiology, transportation, etc.). There are lots of carve outs and exceptions, so I’m skeptical of how much this really fixes, but it’s a start at least, going into effect in 2022. I’m sure much more will be written on the implications here soon.
  • Financial Aid Changes – Student Loan Application (FAFSA) simplification – lots of changes here, but they don’t go into effect until 2023. In the interest of time, I’ll table this one for now. Just know there are changes coming. Additionally, the number of Pell Grants will be increased.

In order to reach a bipartisan agreement, both of the following WERE NOT INCLUDED in the Act:

  • Business liability protection (i.e. can’t sue if you get covid at a business as long as they were following CDC guidelines), which Republicans wanted
  • State and Local Aid above and beyond that specifically budgeted for the items in the Act, which Democrats wanted.

I suspect there will be more to come, though the type of relief/stimulus likely depends on the outcome of the GA Senate run-offs. There is already a proposal to increase the $600 direct payments to $2000, supported by the House and the President, but that will have a difficult time in the Senate. We’ll have to wait and see what happens.

Special 2020 Deduction For Non-Itemizers Giving To Charity

It’s Giving Tuesday, so here’s a special reminder about this year’s “bonus” charitable deduction. As part of the CARES Act, Congress authorized a special charitable deduction for 2020 for people who aren’t able to itemize due to the standard deduction being higher than their itemized deductions. The limit is $300, and that’s the case whether your Single, Head-Of-Household, or Married Filing Jointly. To qualify, the donation must be in cash, it must be to a qualifying organization (which is the same as for charitable donations as itemized deductions), it must be made in 2020, and appropriate records must be kept. As with itemized deductions, you can check whether the organization qualifies using the IRS’s Tax Exempt Organization Search. A $300 deduction may not sound like a lot, but many people have already made, or are about to make, some cash contributions for friends, colleagues, or family members that are raising money for various organizations. If you’re going to make the contribution regardless of the tax benefit, you might as well take the tax benefits that are available. In most cases, substantiation simply requires an acknowledgement from the organization (including stating that you received no benefits for your donation) and a cancelled check or credit card statement. (For detailed record keeping requirements and special cases, see Charitable Contributions – Deductions & Recordkeeping in the blog archives.) So save those “thanks for your contribution” acknowledgement emails and keep a running list of your cash donations this year, whether you itemize or not. They will come in handy to the tune of up to $300 in deductions at tax prep time.

Election Blues (And Reds)

Given the market volatility around the 2016 election results and election day tomorrow, I thought it would be a good idea to do a Q&A-style post about the election and its potential impacts.

Q: Who’s going to win the presidential election?

A: There’s no way to know for sure at this point, and it’s pretty likely that we won’t know tomorrow night either. But, if you believe the polls and the work of statisticians such as Nate Silver (fivethirtyeight), Biden has about a 90% chance of winning. If you believe the betting markets, Biden has about a 60% chance of winning. These are two very different ways of analyzing the election probabilities. Analyzing the polls is essentially using the estimated margin of error in each poll and weighting the polls by their likely accuracy to determine the mathematical chance of the overall margin of error being big enough for Biden to lose and Trump to win despite the polling averages showing a lead for Biden on average. The betting markets on the other hand are showing the odds that a bettor on Biden would be willing to take (betting $3 for a chance to win $2 more) vs. what a Trump better would be willing to take (betting $2 for a chance to win $3 more). The betting is purely opinion-based and is an average of what all bettors think is going to happen in aggregate. It’s possible that both are somewhat skewed. I don’t really believe the hype around Trump supporters lying to polls, but it’s possible that they’re harder to reach to poll. It’s also well known that the betting markets are male-dominated and that Biden’s lead over Trump is much lower among men than women. Since people often bet in a way that favors what they’d like to see happen, that could skew the odds toward Trump’s side. If I had to guess, I would go somewhere in between and say that Trump has about a 30% chance of winning. That means I’d be willing to bet $3 to win at least $7 on him, or be willing to bet no more than $7 to win at least $3 on Biden. 30% is not zero. The favorite doesn’t always win, as we saw in 2016. A good baseball hitter gets a hit about 30% of the time. There are lots of hits in baseball. There are more outs though.

Q: What about the Senate?

A: 538 gives the Democrats about a 75% chance of taking control of the Senate (including a 50-50 split with a Democratic president), with the most likely scenario being 51-49. Betting markets. again, have the race closer with Democrats having a 60-65% chance of winning. The closest races are in GA (2), NC, IA, ME, and MT. Interestingly, the second GA senate seat is a special election to fill a vacant seat and has multiple candidates from both parties. If a majority isn’t reached, a runoff will take place on January 5, 2021. That could be the seat that decides control of the Senate and a runoff has a decent chance of happening at this point.

Q: What impact will the election results have on the stock market?

A: I don’t think that answer would be clear even if we knew today exactly how every race would turn out. That’s because there are so many potentially offsetting impacts. Here are some of the possible scenarios:

  • Biden wins, the Democrats take control of the Senate by several seats, and the Democrats keep decisive control of the House – corporate tax rates likely increase (clearly bad for stocks), taxes on higher income individuals likely increase (probably bad for stocks, at least short-term), higher regulation (probably bad for stocks, at least short-term), large stimulus package gets passed (probably good for stocks, at least short-term), more certainty (probably good for stocks), less pressure on global trade (probably good for stocks) less political angst (impeachment, oversight inquiries, etc… probably good for stocks).
  • Biden wins and the Democrats control the Senate and the House by a small margin – tax picture a little more blurry, regulation still likely to increase, still likely to get a large stimulus package, but allocation to state/local may be a bit smaller, still a boost to global trade, a little less certainty, still less political angst.
  • Biden wins and the Dems & Republicans each control one chamber – tax changes are unlikely (probably good for stocks as a relief to the alternative), smaller stimulus likely (probably bad or less good for stocks at least short-term), still a boost to global trade, more political angst.
  • Trump wins and the Dems control both chambers – tax changes very unlikely, large stimulus likely, much more political angst, and global trade challenges continue (worsen?).
  • Trump wins, the Republicans hold the Senate, and Democrats hold the House (status quo) – tax changes unlikely, stimulus likely smaller with less support for state/local and maybe a big battle to get it done at all, political angst steady, and global trade challenges continue (worsen?).

Longer-term, I really don’t think it matters who wins. Take a look at the chart below from Capital Group:

Sure, there are some dips in that chart, but for the most part it’s a steady upsloping line for 87 years regardless of party. By the way, I don’t think one can make any conclusions about which party is better for the market from that chart because the market prices in election results prior to the election and certainly prices in likely policy changes between election and inauguration. The takeaway should be that from a purely stock market perspective, if you zoom out far enough, it doesn’t really matter who wins a single presidential election.

Q: You said that we probably won’t know the result of the election tomorrow. Why not? When will we know?

A: Each state has their own method of counting ballots. The NY Times recently attempted to summarize those methods. The battleground states have some significant differences. Florida, for example, has already counted many ballots received by mail and will release those counts along with in-person early voting by 8:30pm eastern. Election Day ballots will be counted through the night, but no additional mail-in ballots are allowed after 11/3. So we’ll know who won FL by 11/4 morning barring a 2000-like “hanging-chad” incident. Ohio also plans to release pre-election day votes 11/3 evening (by 8pm) and will count election day votes through the night. But, in stark contrast to FL, they will allow ballots postmarked by 11/3 and received by 11/13 to count, and then won’t provide updated results as those ballots come in. As of 11/2, officials say that full statewide results may not be known until the election is certified by the state on 11/28. Since the state knows how many mail-in ballots were sent out, it will know the maximum that could be received, but if neither candidate leads by enough to make it statistically impossible for the mail-in ballots to swing the results, it sounds like Ohio can’t be called until 11/28! 538 recently published a graphic with their opinion of the state-by-state portion of the vote that should be counted on election night:

There is a chance that one of the candidates will have enough of a lead in battleground states, that that ballots received and counted after 11/3 won’t matter and the election results could be known on 11/3 or 11/4. Again, we can rely somewhat on betting markets to gauge opinion of the probability. PredictIt has a wager on when the election will be “called” by both CNN and Fox News. That wager shows the odds of being called on:

  • Election Day = ~23%
  • November 4th = ~31%
  • November 5th = ~7%
  • November 6th or 7th = ~6%
  • Later in November = ~18%
  • December or later = ~15%

Personally, if I were a betting man, I like the combination of after 11/4 for better than even odds. Maybe that’s more of an emotional hedge though. I certainly hope for a result by the 4th!

Q: What’s the market going to do if we don’t know who won or if the election is contested?

A: We know the stock market didn’t like the 2000 election result process (the FL “hanging chad” election), but it wasn’t exactly catastrophic, as the chart of the S&P 500 shows. It also wasn’t long-lasting.

A contested election that results in not only recounts, but lawsuits that potential swing a result from one candidate to another, etc., could be temporarily much worse. But it’s unlikely that an election with a large margin of victory would be contested and even lower chance that it would reverse the result. So, a very close election with no clear result, that leads to social unrest could certainly hurt financial markets temporarily. Some unrest is likely no matter what the result given current political polarization. The less clear the result is and the more it seems to change, the higher the risk of extreme volatility. I have a high degree of confidence that the next president will be inaugurated on January 20th, regardless of how the election goes. With all of that said, the stock market does a very good job of factoring-in event probabilities and their impacts (including support by the Federal Reserve if things really go off the rails). That means the market is likely to respond very positively, all else being equal, to a clear winner. There’s no way to game the system without a crystal ball or time machine.

Q: Give it to me straight, all-in-all is tomorrow night going to be a mess for the stock market?

A: If you define mess as volatile (bouncing sharply in either/both directions), I’d say that’s much more likely than on an average night. If you define mess as the market falling sharply, I don’t think anyone knows in advance. The better question though is whether what happens tomorrow night matters. I made this short post at about 11pm on election night 2016. Stock futures were down 4.5% at the time and got slightly worse as the result became clear. By 8am, futures were barely down. By the close on 11/9, stocks closed up a little over 1% from the election day close, completely reversing the overnight pullback. By the end of 2016, they were up almost 10% from the day of the election and even now, mid-pandemic, they’re still up over 50% (S&P500) from that election. People are on edge over the election for reasons that far outweigh finance. I get it. The moral of the story here is that there’s little/no reason to let predictions of, or even actual, stock market volatility add to your anxiety.

To summarize:

  • For the markets, the election is all about probabilities. While Biden is favored to win and the Democrats are favored to narrowly take the Senate, neither is anywhere near a sure thing.
  • There are dramatic, offsetting impacts to the economy and financial markets, at least short-term, in every possible scenario. Each is currently priced in, probability-weighted.
  • It may take a while for election results to unfold with certainty.
  • It may be chaotic in the markets for a while and that could include big down or up moves as a clearer picture of the future arrives.
  • Long-term, the 2020 election barely matters from a financial point of view. If you’re feeling anxious, try to zoom out for perspective. Stick to your plan. Things are going to be ok.

Note: Many of the links in this post are being updated periodically with new information as election information evolves (538, NY Times, etc.).

Q3 2020 Returns By Asset Class

This post contains the usual returns by asset class for this past quarter (by representative ETF), as well as year-to-date, last twelve months, last five years, and since the financial crisis lows of 3/9/2009.  While there is still no predictive power in this data, I’ll continue to post this quarterly for those of you that are interested. 

Q3 2020 (7/1/20 – 9/30/20)
Year To Date 2020 (1/1/20 – 9/30/20)
Last 12 Months (10/1/19 – 9/30/20)
Last 5 Year (10/1/15-9/30/20)
Since ’09 “Bottom” (3/9/09 – 9/30/20

A few notes:

  • Q3 was another strong quarter with positive returns across major asset classes. Commodities (+10.5%) led the way with strong gains in metals, followed by Emerging Market Stocks (+10%), and US Large Cap (+9%). Foreign Developed and US Small Cap stocks were each up 6% with High-Yield (“Junk”) Bonds up 4%. Emerging Market Bonds, Aggregate US Bonds, Short-Term US Credit Bonds, and Real Estate Investment Trusts followed with returns in the 0.5-2% range.
  • US Large Cap Stocks are the only major equity asset class that has fully recovered from the covid sell-off and is now positive on the year. US bonds (both aggregate and short-term credit) are also positive, no doubt helped by the various Federal Reserve bond-buying programs. The Fed continues to buy both corporate bond ETFs and a diversified set of individual company bonds subject to their self-defined constraints.
  • The 5-year chart shows major outperformance by US Large Caps as the largest companies have had the best returns in recent years. Large Cap Growth (not shown) has done even better as the tech sector of US Large Cap (think Facebook, Apple, Amazon, Netflix, Google, etc) has done even better. Commodities have lagged badly, as energy has been repeatedly crush, first by a glut of supply with US shale entering the market en masse, and then by a demand shock due to covid.

Donor Advised Funds: Maximizing The Tax Benefit of Charitable Contributions

Do you make charitable contributions but find that you can’t deduct them for tax purposes because the standard deduction exceeds your itemized deductions?  If so, you can use something called a Donor Advised Fund (DAF) to group multiple years’ of future charitable deductions into one year for tax purposes and realize an immediate tax benefit.  This isn’t just shifting tax from one period to another as is the case for many tax strategies.  This will result in reduced taxes… more of your money kept in your pocket, or alternatively, more money you can give to those charities.

The Tax Cuts & Jobs Act (TCJA) imposed a limit of $10k per year that can be deducted as an itemized deduction for State & Local Taxes (SALT) paid each year.  Note that is true for both single and joint filers (i.e. the cap is not doubled to $20k for joint filers).  Additionally, TCJA doubled the standard deduction from $6k single & $12k joint to $12k single and $24k joint (inflation adjusted each year).  Finally, with depressed interest rates, many have been able to refinance their mortgage in recent years, leading to less of a mortgage interest deduction.  The combination of these factors has led to more and more filers taking the standard deduction rather than being able to itemize, meaning no additional tax benefit for charitable contributions.  With another wave of refinancing in 2020, even more taxpayers will find themselves in this situation. 

Let’s use some real numbers to demonstrate.  For 2020, the standard deduction is $12,400 for single and $24,800 for joint filers.  Let’s say that you’re married and your state income taxes and property taxes paid exceed the $10k limit, so you’d get $10k for SALT deductions in total due to the cap.  Let’s also say you have a $350k mortgage at 3% fixed, resulting in ~$10.5k of mortgage interest for 2020.  Finally, let’s say you give $4k per year to charity.  Since the SALT (10k) + mortgage interest (10.5k) + charitable contributions (4k) only total $24,500 of itemized deductions vs. the $24,800 standard deduction, it means that whether you made the charitable contributions or not, you’d still take the standard deduction.  You therefore get no tax benefit from the charitable contributions.  In fact, even if your total itemized deductions exceed $24,800, if the SALT + mortgage interest alone don’t exceed it, then some portion of your charitable contribution will provide no tax benefit.

If only there were a way to group several years’ worth of charitable contributions into a single year so you’d exceed the standard deduction (by a lot!), get a large tax benefit in that one year, and then take the standard deduction in the future years.  Enter the Donor Advised Fund.  A DAF is just an account with a DAF provider to which you make a lump sum contribution in a given year.  Since the contribution is irrevocable, and the DAF is a non-profit itself, you get to take the full amount of the contribution as a deduction in the year in which it’s made.  The money then remains in that account (it can even be invested) and you can make grants out of the account at any time to the charities of your choice.  Almost all charities, non-profits, and religious organizations are supported, though check with the DAF to make sure the organizations you want to support are allowed before making your contribution.

Back to the numerical example…  Instead of donating $4k each year for 5 years, you contribute $20k to a DAF in 2020 and then use the DAF to make $4k per year grants to the organizations you wish to support from 2020 – 2024.  In this case, your total deductions in 2020 amount to $40,500 (10k SALT + 10.5k mortgage + 20k charity) allowing you to itemize.  You’d then still take the standard deduction for the next four years.  The benefit is over $5500 of tax saved!

Even better, if you have highly appreciated assets, you can donate those and take a deduction for the fair market value of the asset, without ever having to pay capital gains tax on the asset’s appreciation.

Now, you may say that you don’t give to charity for the tax benefit, so who cares.  And it’s true.  No one gives to charity for the tax benefit because at most, you’d save $50 cents of tax for every $1 you donated which is clearly not a winning strategy.  But if each $1 you donate only costs you $0.50 cents with a tax benefit, then you could afford to donate twice as much with the tax benefit than without.  Therefore, whether you’re doing it to reduce your tax bill and keep more money in your pocket, or you’re doing it so you have more to donate to the charities (think of it as a government match facilitated by the tax code), there is a clear benefit to donate in a way that will allow you to take a tax deduction.

The typical DAF does charge an asset-based fee, but it is fairly low, in the 0.6-1.0% per year range.  The tax benefits of the DAF almost always outweigh any costs involved.  DAF providers typically cut off new account openings in early to mid-December in order to make sure they can get everything done by the end of year tax deadline, so if you’re interested in opening and funding a DAF, it is best to do so well in advance of end of year. 

In summary, DAF’s have low costs, allow you to reap substantial tax benefits, and still allow you to support the organizations that you typically support.  If your SALT deduction + mortgage interest deduction are below the standard deduction, and you make charitable contributions, you would almost certainly benefit from a DAF. 

Recent Executive Actions On Unemployment Benefits, Payroll Taxes, Student Loans, & Housing Assistance

On August 8, President Trump issued executive orders related to the extension of expanded unemployment benefits, the deferral of employee payroll taxes, an extension to the waiver of student loan payments and interest, and a directive to various cabinet members to take action to prevent residential evictions and foreclosures resulting from financial hardships caused by COVID-19. These orders were an attempt to circumvent the need for congressional action on additional COVID-19 assistance, which seems to have at least temporarily, resulted in a standoff in the Senate. The provisions in these orders are complicated and may result in legal challenges. There has been some additional guidance issued by the Dept. of Labor and FEMA, both of whom are involved in implementation. Below is a quick summary of what I understand so far related to these orders.

Unemployment – the CARES Act provided $600 per week of federally funded unemployment insurance benefits, in additional to standard state funded unemployment benefits. The additional $600 per week benefit expired on July 31, 2020.  This executive order and supplemental guidance authorizes states to voluntarily apply for aid from FEMA to fund an additional $300 per week benefit from August 1 through December 27, not to exceed $44 billion (which would only last about 5 weeks given the number of currently unemployed people). While the original order called for a $400 per week benefit, only 75% was to be Federally funded, with states picking up the additional 25%. Given fiscal issues at the state level, additional guidance was provided that states could treat their $100 per week as additional unemployment compensation or as a portion of their existing unemployment compensation paid (i.e. make the additional benefit $400 by taking the FEMA $300 and adding $100 to the current amount they pay OR make the benefit $300 by taking the FEMA $300 and treating $100 of the current unemployment benefit calculation as part of the program). Participation is up to the states and many seemed to be waiting for the supplemental guidance on their $100 per week portion before applying. To date, SD has announced it will not participate and AZ, CO, IA, LA, MO, NM, and UT have applied and been approved. It is unclear when payments will be able to begin for participating states due to administrative delays in changing unemployment systems to comply. Some states may begin in late August, with others starting payments in September. Some states, like SD, may choose not to participate at all. In order to receive the $300 or $400 supplement, individuals need to be collecting unemployment at a rate of at least $100 per week and must certify that they are unemployed or partially unemployed due to the disruptions caused by COVID-19.

Payroll Taxes – this order directs the Treasury Secretary to defer the collection of the employee portion of social security taxes (currently 6.2% of the first $137,700 of wages earned in 2020), for Sepember 1 – December 31 without interest or penalties. It also directs him to “explore avenues, including legislation, to eliminate the obligation to pay the taxes deferred” (i.e. forgive the taxes, rather than just defer them). This would apply for workers earning less than $4000 per bi-weekly period (adjusted equivalently for other payroll periods). Additional guidance is required from the Treasury Secretary as to how this program will work. In practice, employers collect Social Security taxes as the FICA portion of payroll taxes. If they fail to collect these taxes, they are generally responsible for paying them on behalf of the employee. That means that if an employer allows an employee to defer the tax to post-12/31 and the employee cannot pay, the employer could be on the hook for these taxes. From an employee perspective, deferral of the tax for a few months isn’t a big help if the bill then comes due in January for the whole deferral period. However, if the deferred taxes are forgiven, that would be a huge help. Payroll taxes can’t really be forgiven without Congressional action though, so forgiveness seems uncertain. Without additional guidance, it would be difficult for an employer to stop collecting the social security taxes. Even if they did participate and offer it to employees, it may cause financial stress in early 2021 for those employees that participate and need to pay the deferred taxes. Of course if there is any chance of forgiveness that is dependent on deferring the taxes to 2021, then employees have a strong incentive to participate as much as their employers allow them to. We’ll have to wait for further guidance to understand how (if) this order will ultimately work.

Student Loans – the CARES Act provided for deferral of student loan interest and payments through September 30, 2020. This order effectively extends that (voluntary) deferral period through December 31, 2020.

Housing Assistance – the CARES Act issued a moratorium on evictions that expired on July 24, 2020. This order does not extend that moratorium. Instead, it directs various cabinet member to take action to find ways to minimize residential evictions and foreclosures during the ongoing COVID-19 national emergency, to review existing authorities that can be used to prevent evictions, to identify funds that could be used to help renters and homeowners, and to consider whether any further halting of evictions are reasonably necessary to prevent further spread of the virus.

Congress has adjourned through Labor Day, so barring any emergency callbacks, which look to be a very low probability at this point, guidance on the programs above is all we’re likely to get from now till then. I suspect there will be another stimulus act passed in September/October, but these executive orders are likely to be it until then.

Q2 2020 Returns By Asset Class

This post contains the usual returns by asset class for this past quarter (by representative ETF), as well as last twelve months, last five years, and since the financial crisis lows of 3/9/2009.  I also added a year-to-date version to show how Q2’s recovery did a fairly good job at offsetting most of the Q1 damage.  While there is still no predictive power in this data, I’ll continue to post this quarterly for those of you that are interested.  Charts shown in the link below, with each on a separate page, legend at the bottom, zoom to your liking):

2020Q2 Asset Class Performance

A few notes:

  • Q2 was a hugely positive quarter, recovering a lot of the Q1 losses. US Small Caps (the worst performers in Q1) led the way in Q2 with a 26% return. US Large (+20%), Emerging Markets (+19%), and Foreign Developed (+17%) weren’t too far behind. REITs (+14%), Emerging Market Bonds (+10%), US “Junk” Bonds (+7%), and Commodities (+6%) were also strongly positive. Even the more conservative US Aggregate Bonds and US Short-Term Corporate Bonds were up 4% and 5% respectively, largely due to support from the Federal Reserve’s bond buying programs.
  • While US Large Cap stocks briefly went positive for the year in late May, the other major equity asset classes have not fully recovered their Q1 losses. With the recent pullback, year-to-date, US Large Cap is down ~3%, with US Small Caps, Foreign Developed and Foreign Emerging Markets all still down 10-12%.
  • US Bonds are now strongly positive year-to-date as interest rates have fallen and Federal Reserve support has offset credit quality concerns in the corporate sector. The Fed continues to buy both corporate bond ETFs and a diversified set of individual company bonds subject to their self-defined constraints.

Setting Contingent Beneficiaries Of Retirement Plans When You Have Young Children

***This post describes some of the complexities in choosing the contingent beneficiary of a retirement plan for parents with young children.  It is intended to help explore options and set up conversations to be had with a qualified attorney.  It is NOT intended to be legal advice.  Please consult a knowledgeable estate planning attorney before making any decisions around your estate plan***

Note: Throughout this post, I refer to the Will as the document that sets the rules for distribution of probate assets and the establishment of any Trusts.  Rather than repeatedly mentioning a Living Trust, which could contain this same language in a Living Trust and Pourover Will setup, I will exclusively refer to the Will.  The complexities and decision points apply to both situations.

When someone with a retirement account dies, that account passes to the decedent’s primary beneficiary as stated on the account.  If the primary beneficiary is already deceased, the account passes to the stated contingent beneficiary instead.  If no beneficiary is stated or no stated beneficiary is alive, then the account passes to the decedent’s estate and goes through probate, following the provisions of the decedent’s will or state intestacy laws if there is no will.

Most parents would want their assets to pass to their spouse if that spouse is alive.  Hence, naming the spouse as primary beneficiary is often an easy choice.  But what if the spouse is not alive?  Generally, the parent would want the assets to pass to the children.  If the children are all old / mature / educated enough to manage their own affairs, naming children outright as contingent beneficiary(ies) make sense.  Some issues arise when the children are not old / mature / educated enough to manage their own affairs.  This is the case I’ll discuss in this post.

The typical estate planning setup that I encounter for parents with young children is a Will for each spouse containing provisions for the establishment of a Trust for any assets left to the children at death of the second parent.  That Trust has formal rules set by the parents describing when the Trustee is allowed to use the funds for the child’s benefit (typically health, education, maintenance, and support), and when the principal remaining in the Trust is to be distributed outright to the child (typically in a lump sum or in stages at the attainment of certain ages or levels of education, or at a particular life event).  This works well for assets that pass through the estate, but retirement plan beneficiary settings supersede any provisions in a Will.

If a child is named as contingent beneficiary of a retirement plan, the rules in the Will that establish a Trust for the benefit of the child are bypassed and instead the child will own the retirement account outright, via a custodian either specified in the retirement plan beneficiary form, if applicable, or as appointed by a court.  In these cases, when the child reaches the Age of Majority (18 in most states), he/she will have 100% control of the assets in the account with no restrictions.  If parents were satisfied with this result, they wouldn’t have set up a Trust for the child in their Will that would prevent unrestricted access to assets until the child is old/mature/educated enough to handle the money.

So what are the other options here?  The parents could name their estate as the contingent beneficiary, or they could name the Trust that is created by their Wills as the contingent beneficiary.  Let’s examine each of these.

If they name their estate, the account will pass through probate and follow the terms of the Will.  If the Will is constructed properly, it will be able to pass a retirement account that is inherited by a child into the Trust that is created by the Will for that child.  That means preserving the structure that prevents unrestricted account access by the child until qualifications (as defined by the Trust) are met to receive that access.  However, leaving a retirement account to an estate can have negative tax consequences.  That retirement account will need to be distributed out of tax-advantaged status over a maximum of five years.  If the account is sizeable, that could mean distributing large amounts of pre-tax income each year, or worse, into the last year if distributions aren’t taken every year.  Since tax rates are progressive, and pre-tax income becomes taxable when distributed, that could mean paying higher than necessary income taxes, thereby foregoing an unnecessary portion of the inheritance to taxes.

If the parents name the Trust that is created for the child in their Will, then again, the structure that prevents unrestricted access by the child at the Age of Majority is preserved.  Additionally, if that Trust qualifies as a “look-through” trust, then the retirement account won’t have to be distributed until 10 years after the child reaches the Age of Majority.  This gives much more time to spread out the distributions of pre-tax income so that they’re not all lumped into one or a few years, causing a high tax-rate to apply.  Note that prior to the passes of the SECURE Act in December of 2019, the distributions could have been spread (or more commonly “stretched”) over the lifetime of the child by taking a small Required Minimum Distribution (“RMD”) each year after the death of the account owner.  The SECURE Act eliminated this “stretch” for most beneficiaries, replacing it in the case of a child inheriting a retirement account by eliminating the RMD requirement, but adding a requirement that the account be distributed within 10 years of the child reaching the Age of Majority. 

So naming the Trust that is created by the Will preserves the restricted access that most parents desire and gives a better tax treatment than naming the estate would.  This seems like the best option for most people, but it too comes with some complexities.  First, as noted above, the Trust created by the Will must be a “look-through” trust.  That means it must 1) be valid in your state of residence, 2) it must only leave assets to a living person (no charities or complex provisions where the ultimate beneficiary of the Trust cannot be ascertained), 3) the Trust must be irrevocable at the death of the retirement account owner (so the terms can’t be changed) and 4) the retirement account custodian must have a copy of the Trust on file.  While not overly difficult, this means the attorney that creates the Trust language must be aware of your intention to name the Trust as beneficiary of a retirement account while still preserving tax-advantaged status for as long as possible. 

Another complexity is in how the Trustee of the Trust will ultimately distribute the retirement account into the Trust and then to the child.  Prior to the SECURE Act, two types of trusts could be used.  One, known commonly as a “conduit trust” would receive RMDs each year from the retirement account and distribute them to the child as income.  This had the advantages of avoiding trust tax rates, which are higher than individual rates, by passing each year’s income to the child, who is typically in a low income tax bracket.  It also meant that only a small amount of the account would be distributed each year, thereby applying the lowest marginal tax rates possible to the inherited amounts.  Remember though that the SECURE Act eliminated RMDs for inherited accounts.  Without RMDs, there is nothing to distribute each year under the conduit trust structure which would leave only one big distribution to the child in the 10th year after reaching the Age of Majority!  If you have a conduit trust structure that doesn’t provide the Trustee with the ability to distribute principal from the retirement account, you have a real mess on your hands.  Those with estate plans already in place should consult with their attorney to make sure this won’t impact them in the post-SECURE Act world. Those building their estate plans now clearly want to avoid a conduit trust setup.  The other type of trust that was used pre-SECURE was known as the “discretionary trust”.  This type of trust would receive RMDs each year but hold them in the Trust rather than distributing them to the child by default.  If the child needed money from the Trust for valid reasons as defined by the Trust, then the Trustee would have discretion to distribute it.  A discretionary trust can still work post-SECURE Act, but the Trustee needs to balance taking distributions from the retirement account to minimize a large bill later with the needs of the child in any given year and the high trust tax rates for any retirement account distributions that are retained in the trust.

A final complexity in naming the Trust that is created by the Will as contingent beneficiary of a retirement account is the skill/experience required of both the attorney that sets up the estate plan and the trustee that is left as responsible for making the distribution decisions.  From my experience, not every estate planning attorney knows how to best create a look-through trust in a will that is capable of preserving tax-advantaged status while maintaining a structure that will prevent the money from reaching the child in unrestricted form too early in life.  Additionally, parents often choose a relative or family friend as the Trustee of the Trust.  That person may not have the experience or understanding of all these complexities to minimize taxes each year and over the life of the Trust.  While an outside advisor can surely be hired to assist, the Trustee may not even realize the complications and the inefficiencies that will result from poor optimization.

Options, pros & cons

Now, you may note that all of this only comes into play if both parents die while the child is still young.  That’s true.  The complexities of a child inheriting a retirement account are only an issue at the death of the second spouse if there are still young/inexperienced children at that time.  That makes the ultimate event where the child actually inherits the account before they’re capable of dealing with it properly a low probability event.  Unfortunately, parents are building assets in retirement plans while their children are young and the possibility of early death still exists, regardless of that low probability.  This means the creation of estate planning documents and naming of beneficiaries in a thoughtful, coordinated way is necessary for all parents that don’t want to risk giving children unrestricted access to large sums of money the day they turn 18 or losing substantial amounts of the child’s inheritance to income taxes.  In other words, you won’t know if your estate planning documents and beneficiary selections are important until exactly that time when it’s too late for you to do anything about them.  Therefore, it makes sense to set them up in a way that will handle this worst case, rather than pretending that the worst case can’t happen to you.

One final note…  I’m often asked if it’s ok to create estate planning documents via an online service that uses templates and fills in the blanks with your answers to interview questions.  If the service is capable of guiding you through the complexities described above such that you can thoughtfully answer the relevant interview questions, and capable of creating documents that address these complexities, then have at it.  Or, if you understand these complexities enough to choose simplifications that will work for you such that the service’s offering can handle your requirements, then again, go for it.  Technology is amazing, but I’m skeptical of this approach.  In my opinion, there is little/no point to an estate plan that doesn’t work and leaves a mess to be sorted out by your heirs.  In some cases a bad estate plan can even be worse than no estate plan at all.  If you’re wealthy enough to have (or assume you will have in the future) sizable amounts of money in retirement plans, then it’s probably worth spending some money to get your estate plan in order with the help of an actual attorney.     

Q1 2020 Returns By Asset Class

For the last several quarters, I’ve posted returns by asset class (by representative ETF), as well as last twelve months, last five years, and since the financial crisis lows of 3/9/2009. While there is still no predictive power in this data, I updated those charts as of the end of Q1 2020 for those of you that are interested.  Charts shown in the link below, with each on a separate page, legend at the bottom, zoom to your liking):

2020Q1 Asset Class Performance

Given all the recent blog posts explaining what’s going on, I’ll provide limited commentary on this.  What started as a fairly positive quarter turned ugly at the end of February and downright brutal across risky asset classes in March.  A few notes:

  • Bonds (many of which are now backed by the Federal Reserve’s purchasing power) acted as dampeners of the poor returns, as expected.  The more aggressive your portfolio, the more stocks and less bonds you have, the more magnified negative returns are for Q1.  The aggregate bond index was up 2% for the quarter while short-term corporate bonds were down about 2% due to the slightly worse, but still investment grade, credit quality of corporate bonds vs. treasuries.
  • Junk bonds and emerging market bonds outperformed equities, but still took a beating in Q1 (-12% and -16% respectively).
  • US Large Cap stocks continued to outperform small caps and foreign stocks.  But while the relative performance was better, the overall returns were still -20%.
  • US Small Cap stocks were the worst performers (-30%) and that was after a spectacular final week of the quarter.  Some portions of the Small Cap world (not shown) were even worse.  Micro Cap stocks (-35%+), US Small Cap Value (-40%+) (not shown).
  • Foreign Developed and Emerging Markets took it on the chin as well, down ~24% each.
  • Commodities in aggregate were down ~30%, but energy had it’s worst quarter of all time after Saudi Arabia & Russia decided to start a price war, pumping extra supply into the middle of the covid-19 global economic shutdown.  Energy as a whole (via Vanguard’s Energy ETF) was down 53% while Oil & Gas Equipment & Services were down a whopping 72% in Q1 alone.