I hope you are staying cool in our July heat. The second half of 2024 promises to be eventful with the upcoming presidential election. Let’s dive into our updates and thoughts.

Market Outlook: Don’t Get Carried Away with Last 9 Months, Clouds Are Gathering

The market’s rally over the last 9 months has far exceeded expectations.  Yet, most stocks have not participated in this rally.  (For instance, until this week, small cap was flat for the year and well below its peak.)

Some other assets like precious metals have done well due to hopes of interest rate cuts and concern over economic and geopolitical stability.  Traditional fixed income, small cap stocks, and base commodities have not performed as well.

The relevant question is not simply looking at the past, but rather considering what to do now and in the near future?

Particularly for those of you in or about to enter retirement, you cannot afford to simply chase the herd.  Potential red signs are flashing.  As much as we seek returns, we also must guard against risks that could hurt your nest egg.

Concerns we see include:

• Potential turning point on the US economy (US consumer health deteriorating, jobs sputtering, commercial real estate declining)
• The Fed still has not cut interest rates (unclear if inflation is actually improving that much)
• Bubbly market behavior (bloated concentration of market performance in less than a dozen names, speculation in limited areas at the neglect of others, “everyone is in the pool” technicals, valuations extreme for the winners relative to history, though the losers appear much less overvalued)
• Geopolitical tension (US November elections, EU elections portend change)

AI is the one thing powering the market – but there exist some similarities to the Internet rage leading up to the year 2000.  (Does anyone remember AOL or Yahoo?  They were some of the darlings in 1999, but we hardly hear of them today.  That is because new winners emerged.)

As a reminder, after NASDAQ peaked in 2000, it sold off and did not recover for nearly 14 years.  Most of you in retirement (and many approaching retirement) simply do not have that much time for your savings to recover from such a potential drawdown if it were to happen again.

Questions exist as to the ultimate economic returns that most companies would actually get on current AI development.  Cost synergies appear feasible, but revenue growth less so.  Undoubtedly, there are many menial, mental processes that could be automated.  Yet, replacing a human worker with a humanoid robot powered by the state of the art chips is nearly double current employee cost.  Robo taxis are the rage, but the reality is that other players in the auto industry rely on the same data and, thus, over time, competitive advantage gets whittled away.

We maintain a defensive stance while looking for opportunities to grow your portfolio even with risks out there.  Your accounts continue to be invested in a variety of sleeves, including growth, income, and diversification.

What Do I Own in the Income Bucket?

“Why do I need anything but NASDAQ stocks?”  Today they rise, but that is no guarantee in the future they will keep rising.  In fact, especially if stocks become overvalued and/or earnings disappoint expectations, the stocks possibly might even fall.  Just remember the year 2000 followed 1999.  After the decline, it took over a decade for investors to recoup losses.

Except for those with the longest time horizons and most aggressive risk appetite, most of you own investments in the “income” bucket.  (Recall in the last newsletter that we discussed the “diversification” bucket.)

The Income bucket is designed to allow you to clip coupons by being paid interest, yet with potentially limited (up or down) appreciation on your principal.  The Income bucket functions to fund short-term needs for cash and potentially stabilizes the total portfolio when volatility rises and risk markets decline.

US Government T-Bills are the primary exposure in those of you with the Income bucket.  Low duration (less than 2-year maturity) and minimal credit risk (US government) along with a mid-single-digit coupon offer potentially attractive risk-adjusted returns.  The greatest risk to returns on T-Bills is the possibility and extent to which the Fed decides to reduce interest rates in response to a weaker economy.  Lower interest rates mean lower (but not negative) returns on T-Bills.  In fact, a cut in interest rates near-term benefits the value of your principal.  However, the bad news is that future yield on new T-bills is lower.

Our hunch is that the Fed might make a moderate cut in rates over the next 18-24 months if and as the economy continues to weaken.  However, we doubt it brings us back to the near zero rates of pre COVID; fiscal spending and debt are at much higher levels.  Lower interest rates might also add gasoline to the fuel of a possible resumption in inflation.

For the most part, we have avoided buying bonds with high duration or credit risk.  (A few accounts with high cash needs might own some highly rated corporate bonds in limited amounts.)  Risk of inflation and economic weakness coupled with low rates relative to the risk one takes in owning the bonds keeps us cautious.

While not officially part of the Income bucket, one mutual fund strategy might provide slightly higher returns with a risk profile similar to fixed income.  This fund utilizes an event driven strategy (officially classified in the Diversified bucket).  We described it briefly in our last newsletter, but here is a brief description.  Roughly 2/3 of the strategy is merger arb, where the fund buys the securities (equities or bonds) of a company that has announced it will be acquired.  The fund hedges its exposure by selling short the equity of the buying company.  These trades tend to be low return but low risk and mostly short term (3-6 months).  The other 1/3 of the strategy is classic event driven, where the fund conducts a variety of short-term strategies around corporate events (one example might be announcements on investor days, where the fund might purchase both calls and puts to anticipate a strong stock reaction positive or negative).  The fund does not generate income in the literal sense.  Yet the fund’s strategies potentially result in low volatility similar to traditional fixed income with the potential for higher returns (and lower correlation to the direction of interest rates).

Keep Your IRA Beneficiaries Up to Date

Why Beneficiary Forms Matter

You’ve spent years building up your IRA, watching it grow, and perhaps even rolling over funds from a company plan. But have you thought about what happens to your IRA after you die? Many people mistakenly believe their will controls who inherits their IRA. In reality, the beneficiary designation form you filled out with your IRA custodian determines who receives your IRA funds.

Completing and Updating Your Beneficiary Form

When you set up your IRA, you named primary and contingent beneficiaries on a beneficiary designation form. This form decides who gets your IRA if something happens to you. It’s crucial to update this form after major life changes, like marriage, divorce, or the birth of a child, to ensure it reflects your current wishes.

Regular Reviews Are Essential

Regularly check your beneficiary form to make sure it’s accurate. Clear identification of all beneficiaries and their shares is vital. If the form is missing or outdated, update it immediately. Problems can arise if the form is lost due to bank mergers or other issues. Completing a new form now can prevent complications later.

Take Action Now

To protect your hard-earned IRA funds and ensure they go to your intended heirs, keep your beneficiary designation form updated and accurate. Regular reviews and updates can prevent legal battles and ensure a smooth transfer of assets to your loved ones.

Sincerely,

Petr Burunov, CFP®
President / Wealth Strategist

The post Client Newsletter 3Q24 appeared first on AWM.

That is not true about income coming from investments. Many of your neighbors forget this fact to their detriment.

One of the major problems people often do not understand is taxes. You can reduce different types of income with different levels of taxation.

Be informed.

What are the issues?

Income comes in many forms. Wages and bonuses you earn, sales or income from hard assets, Social Security, and sudden wealth are examples.

For many people, especially those in or approaching retirement, income from their investments is a major way to fund their lifestyles.

Some people lump income into one big category. For those of us who pay taxes (hint: most people pay taxes!), this would be a mistake. The IRS and state tax authorities view income under several categories.

The table below illustrates the different categories of income from a tax perspective and typical sources of such income:

Introducing Different Tax Categories of Income

The table below sheds light on how tax laws might apply for each category of income. This includes both taxable and qualified accounts (typically IRA’s or other retirement accounts).

Different Tax Treatment for Sources of Income in Taxable and Qualified Accounts

Here is some additional color on the specific tax treatment of each of these categories:

1. Ordinary income

   1. Taxable accounts
      1. Income other than long-term capital gains. Wages, salaries, and dividends are examples.
      2. Ordinary income is taxed under the marginal tax bracket as defined by the IRS.
      3. A range of itemized deductions might be able to offset a portion of ordinary income.
   2. Taxes on ordinary income are not relevant when held in retirement accounts.

2. Qualified Dividends

   1. 1. Taxable accounts
         1. Taxed at the long-term capital gains tax rate (used for gains on the sale of investments held for greater than 1 year).
         2. No cost basis, but also favorable tax treatment due to (typically) lower long-term capital gains tax rate.
      2. Only offset on income tax returns is capital losses (selling assets below purchase price and writing off all or a portion of the difference).
      3. Taxes on qualified dividends are not relevant when held in retirement accounts.

3. K-1 Income Pass-through Income

   1. Tax considerations for taxable accounts

      1. Partnerships like LP’s and Master Limited Partnerships (MLP’s), both public and private, pay income that the IRS treats differently from ordinary income.

      2. Investors at the end of each year receive a form K-1. A good portion of your income should be tax-deferred. However, there are complexities:

         • Most income qualifies as “return of capital”, which is recorded for tax purposes not as income, but rather as a reduction of the cost basis of the shares the investor purchased.
         • If and when the investor sells the shares of the partnership, the investor will pay capital gains tax on the difference between the share price and the cost basis. Hence, the return of capital is considered “tax-deferred” into the future, not “tax-free”.
         • Unrelated business taxable income (UBTI) is “income regularly generated by a tax-exempt entity by means of taxable activities.” Not only is this income taxed, but it has the potential to bump up the investor’s marginal tax bracket if it causes the investor’s total income to exceed certain thresholds.
         • Taxable income from MLP’s might offer potential offset in the form of depreciation and other deductions. List these items on your K-1.

      3. You might have to file income tax forms in states where you do not live but where the MLP might do business.

         • According to the MLP Association: “Because of the pass-through structure of MLPs, unitholders in multistate MLPs may owe tax in each state in which the MLP earns income. The K-1 package provided to you by the MLP each year includes information on how much income has been allocated to you in each state.”
         • Apart from a couple of states, most states have low thresholds as to how much income triggers a state income tax filing.
         • You might want to discuss with your professional the need for additional state income tax filings, payments, and whether you want to put up with the burden going forward.
   2. Taxes could still be quite relevant even if held in retirement accounts (such as IRA’s).
      1. Retirement accounts (IRA’s) – if total UBTI on all your investments in an IRA exceeds $1,000 in a year, you must file a special form and pay tax on it.
      2. In addition, you will need to file a special form with your 1040 (Form 990-T).

    

One additional consideration specific to income generated from investments with a foreign domicile is withholding tax.

Some countries have tax treaties with the US and do not withhold additional tax from dividends. However, others do not. The situation varies by country.

The UK poses an interesting example for foreign investors. Sometimes, certain structures (such as UK corporations) are exempt from dividend withholding tax. Yet, other structures in the same country (such as UK REITs) are subject to dividend withholding tax.

How we can help you deal with the issues

We would be happy to schedule a free consultation so we can help you figure out the best ways to generate income after taxes.

Do not go broke by stretching for income! Read our white paper to learn the 3 common potholes you need to steer clear of.

Schedule Appointment

The post Not All Income Is Equal Because of Taxes: 3 Types of Income appeared first on AWM.