Month: November 2021

7.12% risk-free?!? Well, sort of…

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There is no free lunch. I’m sure you’ve heard that statement before. As it relates to financial markets, it generally means that you can’t get an expected return above the risk-free rate without taking some level of risk. The higher the potential for return, the more risk must be embedded in the investment. Currently, there is somewhat of an exception, at least for the short-term, courtesy of the United States government.

Savings bonds are generally poor investments for the long-term. There are many types (“series”) of savings bonds and all but one are beyond the scope of this post. The exception, Series I Savings Bonds (“i-bonds”). These bonds are unique in that their variable interest rate is determined by a fixed rate, set by the Treasury at issuance (currently 0% and never below 0%) and a variable rate tied to the CPI (Consumer Price Index). The fixed rate portion is intended to reflect the “real” risk-free rate (i.e. net of inflation), with a 0% floor, while the variable portion is intended to reflect inflation. In this way, i-bonds pay an inflation-protected risk-free rate. Because of the current bout of inflation, the CPI increased by just over 3.5% in the last six months ending in September 2021. The variable portion of the i-bond rate is recalculated every six months based on the annualized change in CPI from the preceding six months. That means that i-bond rate for November 2021 through April 2022 is the 0% fixed rate + 7.12% variable rate = 7.12%. These bonds are backed by the full faith and credit of the U.S. Treasury, meaning they are about as default risk-free as can be and they’re currently paying 7.12%! So what’s the catch? There’s no free lunch right? No catches per se, but there are some things to be aware of…

First of all, that 7.12% is variable and will reset in May of 2022 based on the change in CPI between November 2021 and April 2022. For each six-month period of time, you’ll receive the variable interest rate, which is not known in advance. It’s unlikely to stay anywhere near 7% over the long-term unless inflation persists. Even then, your return will always only equal inflation. In normal times, that’s not much of a goal, but in a world of negative real interest rates, keeping up with inflation alone may appeal to at least some investors. While it’s unlikely to beat equity investments over the long-term, it’s certainly better than a savings account at one of the major banks paying 0.01%. But there are a few more disadvantages here…

Second, you are required to hold i-bonds for a full year from purchase. I know what you’re thinking… there’s always a way around requirements like that (CD’s charge some interest penalty for example, or illiquid investments that can be sold at below-market prices in case of emergency). Unfortunately, there is no work-around in this case. One full year holding period is required and there is no way to liquidate during that time. Beyond the one-year holding requirement, you can liquidate at any time, but, if you liquidate during the first five years, you are charged a three-month interest penalty (e.g. if you hold for 18 months, you only get the interest for the first 15 of those months). Once you’re past five years, the bond becomes fully liquid with no penalty, and you can hold it for up to 30 years when it will mature and stop paying interest.

Third, you can only purchase $10k of i-bonds per entity per year. What does “per entity” means? It generally means per person, but if you have a business or a trust, those entities can purchase $10k per year as well. So there’s no way to park hundreds of thousands of dollars in i-bonds for the short-term while they’re paying this rate and then liquidate them if rates fall over the next few periods.

Fourth, because i-bonds pay interest rather than qualified dividends or capital gains, that interest is taxed as ordinary income taxed at your highest marginal tax rate (meaning your after-tax return is going to be well less than the rate of inflation). On the plus side though, that interest is deferred until the year you cash in the bonds, so you can choose an otherwise low-income year to keep the marginal tax rate down. Also, as an obligation of the federal government, they are state income tax free, which makes them a bit more appealing if you live in a high income tax state.

So, what’s the bottom line? Should you run out and buy $10k of i-bonds as soon as possible? Well, they’re not a great long-term investment, paying a guaranteed after-tax rate that is less than inflation. They’re not a good emergency fund given the one-year holding requirement. But, right now, in a negative real risk-free rate environment, the fact that the fixed rate portion of the bond cannot go below 0% makes them appealing for those who have significant savings in cash, beyond an emergency fund and other liquid assets. If you’re the type of investor who likes to have a surplus of cash, beyond what you’d need over the course of a year in the case of an emergency like a job loss or disability, this can be a good place to park $10k ($20k if married, $40k if married with trusts, $60k if married with trust and two businesses). It can also be a good replacement for part of the (especially short and/or inflation-protected) bond portion of an asset allocation, since it’s going to pay a higher rate of return, at least for now.

If you decide that i-bonds are for you, you can’t purchase them or hold them in a bank or brokerage account and your financial advisor can’t buy them for you. You’ll need to go to www.treasurydirect.gov and buy them directly from the US Treasury. Opening an account is fairly straight forward and you can link a bank account quickly which will allow you to schedule a purchase right away. If your information is mismatched with something in the Treasury databases, you may have to mail in a form with a Signature Guarantee (like a notarization, but obtained from a bank) to prove your identity. This is also likely if you open an account for a Trust or a business. Once the account is opened an a purchase is made, you’ll see interest being credited after the first three months you hold the bond (that’s the three-month penalty you’d incur if you sell in the first five years). You can track the bond values over time as they accrue interest and can purchase more in future years as desired. Just remember, you’ll always earn the fixed rate that was in place when you purchased the bond (currently 0%) + the variable rate for each six-month period going forward.

You can find more details about i-bonds at the Treasury’s FAQ page for i-bonds.

Special 2021 Deduction For Non-Itemizers Giving To Charity

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Giving Tuesday is coming up at the end of November, so here’s a special reminder about this year’s “bonus” charitable deduction. As part of the CARES Act in 2020, Congress authorized a special charitable deduction for 2020 only for people who aren’t able to itemize due to the standard deduction being higher than their itemized deductions. The limit was $300, and that was the case whether Single, Head-Of-Household, or Married Filing Jointly. The Taxpayer Certainty and Disaster Tax Relief Act of 2020, passed late last year extended this deduction into 2021 and doubles it to $600 for joint filers.

As with last year, 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 by 12/31 (2021 this year), 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 or $600 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 or $600 in deductions at tax prep time.

Updates on Infrastructure & Build Back Better

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As many of you know, the Infrastructure bill passed the House last week in a late night Friday vote. It had already been passed by the Senate and now waits for President Biden to sign it into law. He’s scheduled to do that via a public signing ceremony on Monday, 11/15. Not much was included in that bill from a tax or personal finance perspective (tighter cryptocurrency reporting requirements was the biggie), so I won’t dive into the details. The full text, all 1,039 pages of it, can be found at the link above.

Next up on legislators’ plates are the Build Back Better Act, funding the government, and an increase or suspension of the debt limit. The Build Back Better Act is the latest iteration of the broader social spending plan and tax changes that I discussed back in September (here and here). Many of those provisions have changed. While they’re nowhere near set in stone at this point, I wanted to provide an update of what’s currently in and what’s currently out (hint: a lot more is out than is in). Full text of BBB as of 11/3/21 can be found here.

  • Higher income tax rates – original plan was to increase the top rate from 37% to 39.6% and compress the tax brackets so that the top brackets begin at $400K Single / $450K Joint. This has been eliminated. If that stands, that means no need to accelerate any income into 2021 from 2022.
  • Net Investment Income Tax (NIIT) changes – subjects pass through active income to the 3.8% NIIT. This is still included and basically means that businesses that became S-Corps to try to avoid paying FICA on the “profits” vs the salary, will now have to pay NIIT on those profits instead.
  • Earned Income Credit (EIC) enhancements – remain
  • Surtax on millionaire income – The 3% surtax on incomes over $5M has been changed to a 5% tax on incomes over $10M and and additional 3% on incomes over $25M.
  • Higher capital gains tax rate – This has been eliminated. This means no need to intentionally realize capital gains to lock in today’s lower tax rate.
  • Change in corporate tax rate – The reduction in rate for small business and the increase in rate for all other business has been eliminated. But, a new 15% corporate alternative minimum tax on large corporations is included and a new 1% tax on corporate stock buybacks is added.
  • Changes to 199A Qualified Business Income (20% small business deduction) – This has been eliminated. All the complexity and current income caps would remain as-is.
  • IRA / Roth IRA restrictions – these have remained though some have been delayed and one has been removed:
    • Contributions to IRAs wouldn’t be allowed if the value of all your IRAs exceeds $10M and income exceeds $400k for the year.
    • RMDs would be required for IRAs/Roths over $10M.
    • The conversion of after-tax dollars from a Traditional IRA / 401k / 403b / etc, would be prohibited, effectively eliminating the Backdoor Roth and Mega-Backdoor Roth strategies. This would begin 1/1/22, which means the end of 2021 is the last chance to use these strategies. It may make sense for those who usually make IRA contributions at tax time for the previous year and then convert to their Roth (“backdoor Roth”) to do this by 12/31/21. It may also make sense to convert IRAs that have after-tax dollars mixed with pre-tax dollars even though this will generate some income in 2021 as it would be the last time to convert the after-tax portion.
    • All Roth Conversions would be prohibited for high income taxpayers after 2031 (this one is a funding gimmick that would pull forward conversions into the 10-year period over which the bill is analyzed to determine its net cost).
    • The restriction on private investments and those that could only be made by “accredited investors” has been eliminated in the latest bill.
  • Reduction in the gift/estate tax exemption – This has been eliminated, meaning the currently scheduled reduction in 2026 remains. No need to scramble and try to gift away tens of millions of dollars in advance of a 2022 change.
  • Changes to grantor trusts to pull them back into the estate of the grantor – This has been eliminated.
  • SALT (state and local tax deduction) – the current $10k limit on deductions was unaltered in the original proposal. The new bill increases the deduction cap to $72,500, but also extends the cap which would have expired in 2025, to 2031. If this goes through, anyone who can delay property tax payments or state estimated tax payments to 2022 would be better of doing that than paying in 2021.
  • Expanded Energy Tax Credits – still included
  • Expanded Plug-In Electric Vehicle Credits – still included
  • Extension of the 2021 enhanced child tax credit – still included
  • Universal Pre-K – still included
  • Credit for other dependents – eliminated
  • Extension and permanence of the 2021 Dependent Care Credit – eliminated
  • Caregiver’s credit – eliminated
  • Paid family and medical leave – still out.
  • Free community college – never made it in
  • Elimination of basis “step up” at death – still not included.
  • Elimination of the ability to borrow tax-free by pledging a securities portfolio – still not included
  • Changes to the taxation of “carried interest” – still not included.
  • “Billionaire’s Tax” – tax on unrealized capital gains of billionaires – still out
  • Medicare dental and vision – never made it in
  • Lower prescription drug prices – never made it in (though there’s talk of brining this back in the Senate)

Remember, all of this is in a high state of flux and nothing is certain at this point. The Senate is likely to produce its own version of Build Back Better and then the House and Senate versions need to be reconciled, voted on again, and signed by the president. Given the differences between the progressive and moderate sides of the Democratic party and the wholesale opposition by the Republican party, the odds of anything getting passed into law by the end of 2021 feel lower than 50%. In fact, current prediction markets are pricing the following for a law that passes by the end of 2021:

  • a 30% chance that income taxes increase in any way (including the currently proposed surtax on millionaires),
  • a 33% chance that the SALT deduction will be modified,
  • a 13% chance of a “billionaire’s tax”
  • a 10% chance of an increase in capital gains.
  • a 6% chance of a corporate tax rate increase.

Not very promising odds, but that doesn’t mean that nothing will pass. It also doesn’t mean that the whole thing isn’t punted into 2022 and passed then.

Updated 2022 Tax Numbers

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The IRS has released the key tax numbers that are updated annually for inflation, including tax brackets, phaseouts, standard deduction, and contribution limits.  Due to rounding limitations, not all numbers have changed from last year, but tax bracket thresholds have increased by just over 3%.  The notices containing this information are available on the IRS website here and here.  Some notable callouts for those who don’t want to read all the way through the update:

  • Max contributions to 401k, 403b, and 457 retirement accounts will increase by $1,00 to $20,500 (+$6,500 catch-up, which remains constant, if you’re at least age 50).
  • Max contribution to a SIMPLE retirement account will increase by $500 to $14,000 (+$3,000 catch-up if you’re at least age 50).
  • Max total contribution to most employer retirement plans (employee + employer contributions) increases from $58,000 to $61,000 (+$6,500 catch-up, again for those 50 or over).
  • Max contribution to an IRA remains at $6,000 (+$1,000 catch-up if you’re at least age 50).
  • The phase out for being able to make a Roth IRA contribution is $214k (married) and $144k (single). Phase out begins at $204k (married) and $129k (single).
  • The standard deduction increases by $800 to $25,900 (married) and by $400 to $12,950 (single) +$1,750 if you’re at least age 65 and single or $1,400 each if you’re married and at least 65.
  • The personal exemption remains $0 (the Tax Cuts & Jobs Act eliminated the personal exemption in favor of a higher standard deduction and child tax credits).
  • The child tax credit reverts back to pre-2021 rules at $2,000 per child, phasing out between $400-440k (married) and $200-220k (single).  Note: it’s possible that 2021 tax treatment may be extended to 2022 or beyond, if the Build Back Better plan passes Congress.  Stay tuned.
  • The maximum contribution to a Health Savings Account (HSA) will increase to $7,300 (married) and $3,650 (single).
  • The annual gift tax exemption increases by $1,000 to $16,000 per giver per receiver.
  • The lifetime gift / estate tax exemption increases to $12,060,000.
  • Social Security benefits will rise 5.9% in 2020.  The wage base for Social Security taxes will rise to $147,000 in 2022 from $142,800.

You can find all of the key tax numbers, updated upon release, on the PWA website, under Resources.