Category: Financial Planning

Some economists and market analysts have been predicting a U.S. recession ever since last fall. They’ve been wrong before – but they’ve also been right. Rather than try to predict how the stock market will react during the next recession, investors are better off planning for a range of potential outcomes. This will help reduce the risk of losses regardless of whether or not the United States experiences a recession in 2023.

Bear in mind that stock and bond markets are forward-looking and typically priced to take into account economic conditions such as higher interest rates, inflation, and commodity prices. In response to whatever factors are in hand, the market adjusts in ways to try to keep returns on par with historical norms and practices.

In its market perspective for 2023, Merrill Lynch suggested that the economic cycle would bottom out, market returns would begin turning a corner, and investors who hold diversified portfolios would see less volatility and be positioned to fully participate in a renewed bull market.

There are several strategies you can implement to help mitigate the impact of an impending recession. Be aware, too, that these strategies are sound all-weather moves designed to help reduce your risk and maximize returns over the long term, regardless of economic and market conditions.

Diversify Your Portfolio

The recent failure of established regional banks is a reminder that there are no “safe” stocks – all stock market investing is subject to a wide range of risks. However, investors should be most wary of owning a high concentration in any single stock. After all, while it is unlikely the stock market will ever be reduced to zero, it is entirely possible for an individual stock to lose total value. This can happen due to a fall in demand, bankruptcy, corruption/embezzlement, a natural disaster, or a public relations scandal. There are many situations that are unforeseen and out of an investor’s control that can lead to substantial losses.

By diversifying your portfolio across a large number of stocks, even those within the same industry (such as competing banks), you can mitigate exposure to a single stock that experiences a major decline in performance. For 2023, Merrill Lynch recommended a broad global stock portfolio with a slight overweight in U.S. equities, including large-cap value stocks and a mixture of small-cap growth and value stocks. It contends that the Energy, Financials, Healthcare, Utilities, and Real Estate sectors offer stable returns via strong cash flow and attractive valuations.

Well-established dividend stocks pay out a steady income as well as offer growth opportunities, which is a good hedge for a strong long-term total return regardless of economic conditions.

Merrill Lynch also favors global fixed-income securities, including investment-grade corporates, 10-year Treasury bonds, and longer-maturity municipal bonds.

Fund Investing

An easy way to diversify across a wide range of stocks and/or bonds is to invest in asset category-specific mutual funds or exchange-traded funds. The immense universe of funds offers a broad range of stocks (e.g., growth, value, large-, medium- and small-cap) and bond (high yield, high quality, government, corporate) fund options. A balanced fund offers a combination of both stock and bond securities to help capture growth as well as capital preservation.

If you invest regularly through a 401(k) plan at work or defer income to an IRA, note that your money will purchase more shares when prices drop, which is often the case during a recession. As long as you have vetted and have faith in your investment choices, this discounted buying opportunity can set up your portfolio for stronger gains once the market recovers.

Cash Allocation

It is always a good idea – even more so during a recession – to hold an allocation in cash or cash-equivalent vehicles such as CDs and money market funds. However, it is not a good idea to sell stocks that have lost ground just to beef up your cash allocation. It may be better to sell a stock with significant appreciation instead, especially if it is in an industry that does not tend to perform well during a recession (e.g., Construction, Manufacturing, Retail, Leisure, and Hospitality).

Estate and inheritance (“death”) taxes are levied on the transfer of property at death. The difference between an estate tax and an inheritance tax is based on who pays the bill. An estate tax is levied on the estate of the deceased, while an inheritance tax is levied on the heirs of the deceased. That’s the simple explanation. As for execution, there are far more nuances based on the monetary value of a bequest; the status of the beneficiary/(ies); and where you live when you pass away.

Federal Estate Tax

An estate tax applies to the value of the assets left behind by a decedent and is paid out from the proceeds of the estate before the rest of the assets are distributed to heirs. Estate wealth is usually comprised of cash, securities, and real estate.

In 2023, if an estate is valued at more than $12.92 million ($25.84 million for couples), the estate will owe a progressive tax rate levied on the value above that amount. For example, if an estate is valued at $15 million, it will pay estate taxes on the $2,080,000 above the exemption. The federal tax rate ranges from 18 percent to 40 percent, depending on the taxable value of the estate.

Generally, the estate tax applies to only the wealthiest 2 percent of Americans, and only 0.07 percent of estates end up paying the tax, according to the Tax Policy Center. Note that assets inherited by a spouse or charitable organizations are generally not subject to an estate tax.

Some states also levy an estate tax based on the location of the property. Presently, 12 states plus the District of Columbia levy an estate tax:

• Connecticut
• District of Columbia
• Hawaii
• Illinois
• Maine
• Maryland
• Massachusetts
• Minnesota
• New York
• Oregon
• Rhode Island
• Vermont
• Washington

Estate Tax Strategies

To minimize or eliminate estate taxes, the estate owner has several options. Among the more sophisticated are structuring an Irrevocable Life Insurance Trust, a Family Limited Partnership or funding a Qualified Personal Residence Trust. However, the easiest way to legally avoid estate taxes is to give assets away before you die. Estate owners can make tax-deductible contributions to charitable organizations or gift up to $17,000 in 2023 ($16,000 in 2022) a year, per person, to as many people as you want.

Inheritance Tax

An inheritance tax, on the other hand, is a state tax paid by the beneficiary (heir) of an estate. Not every state levies an inheritance tax, and the laws vary considerably by state. The tax is based on the relationship of the beneficiary to the decedent. For example, in some instances, a beneficiary who is a surviving spouse, parent, child or grandchild may be exempt from the tax, whereas a brother, sister, niece or nephew may be subject to an inheritance tax.

Presently, six states levy an inheritance tax (only Maryland levies both estate and inheritance taxes). Each state sets its own exclusion amount, ranging from $1 million to $9.1 million. Amounts above the state exclusion are then subject to a separate estate tax, which tends to range between 1 percent and 18 percent. The tax applies to decedents who lived in one of these states:

• Iowa (phasing out tax by 2025)
• Kentucky
• Maryland
• Nebraska
• New Jersey
• Pennsylvania

Inheritance Tax Strategies

Similar to estate tax strategies, an estate owner can minimize state inheritance taxes by transferring assets to a trust or family limited partnership or by gifting assets. Be aware that assets owned under a Roth IRA or Roth 401(k) – that has been open for at least five years – are not subject to any taxes since contributions were already taxed and earnings grow tax-free. You also might consider using a portion of your assets to purchase life insurance, naming your heirs as beneficiaries. Since life insurance proceeds are not taxable, this is a way to remove money from the estate to create a larger, tax-free inheritance.

As for current estate assets, one surefire way to legally avoid inheritance taxes is to move to a state that doesn’t levy them.

The Roth IRA is a retirement savings account in which you invest only after-tax dollars. Subsequently, all earnings grow tax-free and may be withdrawn tax-free. However, there are limits to who can contribute and how much they can contribute to a Roth IRA.

Federal rules restrict direct contributions to a Roth IRA for high-income earners. In 2023, a single, head of household, or married, filing separately tax filer may contribute up to $6,500 if under age 50; $7,500 if 50 or older. However, if the investor has a modified adjusted gross income (MAGI) above $138,000, he is permitted only limited and phased out contributions up to a total annual income of $153,000, above which he cannot contribute to a Roth. Limited contributions for an investor who is married and filing jointly begin at $218,000 in annual income and phase out at $228,000.

However, there is a way to work around these contribution rules using a Roth IRA conversion. To optimize this strategy, investors may be able to conduct a Mega Backdoor conversion from their employer-sponsored retirement plan to a Roth.

The Mega Backdoor Roth strategy is suitable in a handful of circumstances:

• When you’ll be able to max out your employer plan contribution
• When your earned income is too high to contribute to a separate Roth IRA
• If you can save more than the 401(k) and IRA combined limits in one year

Employer Rules

To deploy this strategy, the investor must check with his retirement plan administrator to ensure that the plan allows for post-tax contributions and in-service distributions. If so, the investor should first max out his income-deferred contributions to the 401(k). In 2023, the maximum 401(k) contribution limit is $22,500, $30,000 if age 50 and older.

However, he may invest a maximum of $66,000 or $73,500 (age 50 and up) in his 401(k) for the year, which is the combined total for employer and employee contributions. For example, let’s say a 52-year-old employee earns $200,000 and defers 15 percent ($30,000) of his pre-tax income. His employer kicks in another dollar-for-dollar match of up to 4 percent of his salary ($8,000). With the deferred total at $38,000, the employee could pitch in another $28,000 in post-tax contributions to his after-tax 401(k) account – to reach the maximum total of $66,000.

The next step is for the employee to take advantage of in-service distributions by immediately rolling over his contributions from the 401(k) to an in-plan Roth option or a separate Roth IRA – before any earnings accrue (to avoid taxes on earnings).

Tax Notes

Once the after-tax funds are converted to the Roth IRA, the money grows tax-free, and the investor can withdraw it as tax-free income in retirement. There also is no RMD requirement for Roth IRA funds at any age. However, note that if the funds are converted to an in-plan Roth option, earnings are subject to a penalty if withdrawn before age 59½. If the funds are converted to a separate Roth IRA, tax-free withdrawals are only available penalty-free for five years after each corresponding rollover is conducted.

The Mega Backdoor Roth strategy is appropriate for high earners looking to minimize taxes on both their current income and their long-term retirement investments.

The College Savings 529 plan offers a way for modest-income families to save and invest for college expenses for their children as early as birth up to college age. When invested 529 funds are used to pay for the beneficiary’s qualifying education costs, earnings are distributed tax-free.

However, a lesser-known advantage for wealthier families is that the 529 plan can be used as an effective tax-advantaged tool for funding college expenses for family members over multiple generations. Basically, the 529 enables the investment to continue growing tax-free for years and even decades after the death of the original owner and beneficiary.

Assets from a 529 account may be used to pay for expenses associated with higher education, including tuition, fees, books, room, and board. The 529 also can be used to pay up to $10,000 a year in tuition expenses for K-12 education and a lifetime total of up to $10,000 in student loan repayments.

No Age or Use Restrictions

The two key components to this planning strategy, referred to a Family Dynasty 529 plan, are that the beneficiary can be changed at any time and that there is no time frame during which all assets must be distributed (including no required minimum distributions).

Note that the selection of a 529 beneficiary is rather broad:

•        Account owner (self)
•        Spouse
•        Child
•        Spouse of a child
•        Brother, sister, stepbrother, stepsister or their spouse
•        Mother, father, the ancestor of either or their spouse
•        Stepfather, stepmother or the spouse of either such person
•        Nephew, niece or their spouse
•        Aunt, uncle or their spouse
•        Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, sister-in-law or their spouse
•        First cousin

While the 529 can have only one named beneficiary at a time, the beneficiary can be changed at any time (such as once a student graduates), leaving the remaining funds for the next beneficiary.

No Contribution Limit

Unlike federal tax filings, many states offer a limited tax deduction on annual 529 contributions. Note that there is no limit to the amount that can be contributed to a 529 account each year. However, there is a limit to how much can be contributed to each 529 account in total, and that amount differs by state, with the range falling between $235,000 and $529,000. Georgia and Mississippi are the lowest at $235,000, and California features the highest limit at $529,000 (note that a California account can be opened no matter where the owner or beneficiary lives). Moreover, there is no limit to how much invested tax-free 529 assets can grow.

One strategy is to fund a family dynasty 529 with the maximum limit in one lump sum. The idea here is that one lump sum invested for tax-free growth offers the potential to fund college education expenses for a vast number of extended family members over several generations. Each time a beneficiary graduates, a new beneficiary is named. If there are multiple students scheduled to attend college at the same time, multiple 529 accounts can be opened with separate beneficiaries.

Changing Owner for Dynasty Plan to Continue

It is likely that when funding over several generations, the original 529 account owner will pass away. A few plans permit change of ownership only in the event of the death or incapacity of the current owner, but most 529 plans allow the change in ownership at any time, as long as the owner has reached the age of majority for that state’s plan. By periodically changing both owners and beneficiaries of the account, the family dynasty 529 can continue to grow and pay for qualified education expenses indefinitely.

The 529 also may be structured so that the account owner is a trust, which makes it unnecessary to change owners as they pass away. A trust can help protect 529 funds from creditors and may contain language mandating that assets can be used only for higher education – thus eliminating the potential for a beneficiary to drain the account with non-qualified withdrawals.

Potential Gift/GST Tax Consequences

Be aware that some state 529 plans may treat a change in ownership as a distributable event and will issue Form 1099 for tax purposes. Also note that when a new 529 plan beneficiary is one or more generations below the most recent beneficiary, distributed assets beyond the annual gift tax exemption ($17,000 for 2023) may be subject to the gift tax. In this scenario, should excess amounts exceed the lifetime gift tax exemption ($12.92 million for 2023), distributions may be subject to an additional generation-skipping transfer tax (GST).

The Family Dynasty 529 plan is best optimized when started early, such as the birth of the first child, and overfunded to the maximum limit. This allows for the best growth opportunity, wherein college expenses may be funded using tax-free earnings, leaving the principal available to grow for the next student beneficiary. Better yet, parents or grandparents can retain control of the account to ensure it is used only for college funding over multiple generations.

Apart from the spike in inflation, 2023 ended the year with a relatively strong economy, boasting an unemployment rate of 3.5 percent (below the market forecast of 3.7 percent) with increases in wages, corporate profits, and economic growth over the past two quarters. Despite the positive data, a slate of companies, including Microsoft, Google, Amazon, Goldman Sachs, and Bed Bath & Beyond, have all announced significant layoffs planned for this year.

Whether the result of a layoff, a new job, or retirement, the reality is that over the course of a career, most people will change jobs several times. The good news is that 401(k) plan assets are portable – meaning you can take them with you. However, it is important to be aware of all your options so that you choose the most advantageous one each time you change employers.

You Don’t Have to do Anything Right Away

The first thing to note is that the income deferrals you contributed to your employer’s retirement plan are yours to keep. However, an employer match may be subject to a vesting schedule. If you do not work at the company long enough to satisfy the vesting schedule, you might lose all or a portion of the unvested assets in your account.

It is not necessary to roll over your 401(k) assets right away; in many cases, you can leave them where they are indefinitely. However, you will no longer be able to make contributions to the plan, receive matching funds, or tap that money for a loan. If the plan has a wide range of investment options, low fees, and expenses and has performed well, then leaving assets where they are may be your best choice.

On the other hand, you should investigate to ensure your plan does not change once you no longer work for a former employer, as some plans charge higher fees for inactive employees. Also, some employers may require you to cash out of your account balance – usually if it is below $1,000. If your balance is above $1,000, that employer must offer you the option to roll those assets into a personal IRA.

Take the Money

If you opt to withdraw the cash value of your account, you will be subject to an immediate tax impact. Your company may cut you a check for the amount withdrawn, but it is required to withhold 20 percent of the amount to prepay the tax you’ll owe. If you have not yet reached age 59½, the IRA will classify the distribution as an early withdrawal. This means you might owe a 10 percent penalty in addition to the federal tax withholding. The balance also may be subject to state and local taxes. All told, you could lose up to 50 percent of the account value if you take an early distribution.

For young adults in particular, it can be tempting to withdraw their 401(k) balance when they leave an employer. They may not have acquired much in assets, not met vesting requirements for the employer match, and figure they have more need for the money now than in 50 years when they retire. However, bear in mind that investments made early as an adult often purchase good, dependable stocks at low prices, with decades for those stocks to appreciate. Holding onto those assets over the long term allows for maximum growth opportunity, whereas withdrawing them means you’ll have to start all over again.

Roll Over Assets to Your New Employer’s 401(k)

Some employer plans will accept transfers from a former retirement plan, but not all of them do. You will have to inquire. If this is an option, recognize that there is no need to roll over right away. You may want to work there for awhile to ensure you’re happy, the company is viable, and you plan to stay there a while. Furthermore, you may have to wait until the next enrollment period to request a rollover, and some employers may require that you work a specific period of time (e.g., one full year) before you can transfer old 401(k) assets to your new plan.

Open a Personal IRA

A third option is to transfer your old employer’s 401(k) assets to a personal individual retirement account (IRA) that you open through a brokerage of your choice. The new brokerage custodian will give you the forms needed to request the formal rollover, and your former 401(k) plan administrator might have forms to complete as well. It is best to have the two custodians conduct the transfer directly so that you never take possession of the funds yourself, which could result in tax penalties if not conducted correctly.

You’ll need to select new investment options (e.g., mutual funds, exchange-traded funds, individual stocks or bonds) for the IRA, and be sure to compare its fees with your old account. By rolling over to an IRA that you manage yourself, you will have a wider range of investment options and can shop for plans with lower fees.

Bear in mind that, moving forward, any additional contributions you make to this IRA will be subject to lower annual contribution limits (in 2023: $6,500 if under age 50; $7,500 for 50 and older) than 401(k) plans as well as the income limitations applicable to a Roth IRA (2023: less than $153,000 Modified Adjusted Gross Income (MAGI) if you are single; less than $228,000 if you’re married and file jointly).

There are three IRA rollover options for 401(k) plan assets:

• Roll over to a new or existing traditional IRA – No taxes are due on the assets you transfer, and earnings continue to accumulate tax deferred until withdrawn. It’s best to directly roll-over the funds from one custodian to another.
• Roll over to a new or existing Roth IRA – This option requires that you pay taxes on the rollover amount in the tax filing year they are transferred. You may use money from the 401(k) plan or pay the tax separately using other assets (the latter is preferable so that your equity continues to appreciate). Once the IRA has been open for at least five years, and you are at least age 59½, contributions and earnings can be withdrawn free of all taxes and penalties. Furthermore, unlike the traditional IRA, you are not required to take minimum distributions (RMDs) from a Roth.
• Roll over a Roth 401(k) to a new or existing Roth IRA – No taxes are due when the money is transferred, and new earnings accumulate tax deferred. Contributions and earnings are eligible for tax-free withdrawals once the IRA has been open at least five years and you are at least age 59½.

Do Something

Leaving your 401(k) with a former employer is a perfectly acceptable option, but you should consider consolidating your 401(k) plans at some point. More and more people are working for multiple employers throughout their careers, and they may lose track of where they hold 401(k) assets. In fact, at the end of 2021, there was a nationwide total of $1.35 trillion sitting in forgotten 401(k) plans.

Don’t let that happen to you.