Client Education

Inflation is a pretty straightforward concept. Still, it is one of those economic variables that can be concerning to some investors. However, a basic understanding of inflation may help ease some of those concerns.

What is Inflation?

Inflation is simply an increase in prices. It can affect a single good or service. Or it can impact all goods and services in the whole economy. Inflation is generally considered to be negative, but it isn’t all bad. There are pros and cons.

The downside is that when goods and services cost more, the dollar doesn’t go as far as it used to. Inflation diminishes the value of money, forcing consumers to make choices about what and how much to buy. It forces them to budget.

The upside is that inflation is typically the result of a robust economy. Moderate inflation is a sign that businesses and consumers are spending. And aggregate spending is what keeps an economy healthy.

What Causes Inflation?

There is an old expression that price is a matter of supply and demand. And for the most part that statement goes a long way to explain inflation.

When an economy is booming and there’s plenty of money available, people are willing to spend it. The more people are out there spending money, the higher demand and the more likely prices are to rise. Economists call this a shift in demand.

Now, sometimes inflation can occur without a shift in demand. Changing supply can also affect prices.

A shift in supply can happen for a lot of reasons. Some are straightforward. For example, a slowdown in production can decrease the number of finished goods coming out of a factory. A shortage of raw materials can do the same thing.

Then there are factors that are less intuitive. For example, if there aren’t enough people coming in to work, it can decrease a company’s ability to fill customer orders. A backup in the supply chain – getting goods from one place to another – can reduce the supply of goods available to consumers. Both can affect inflation.

A real-life example of these phenomenon was created by the COVID-19 pandemic. Many people missed work, factories were not producing at capacity and there was an overall slowing of the global supply chain.

Should you be Concerned About Inflation?

Americans have gotten used to very low inflation for a very long time. It has averaged right around three percent since 1980. That may be why recent increases in inflation have concerned some investors.

But the correlation between inflation and long-term investment performance is not perfect. Still, inflation has had an impact on other economic indicators. For example, inflation can affect interest rates, which then impacts stock and bond prices.

So, the degree to which investors should be concerned about inflation may depend on the type of investments they own, their age and their circumstances.

Working with experienced financial professionals can help you stay the course. They can provide guidance and encouragement to help focus your attention on your long-term goals.

Sequence of returns risk is the uncertainty that a portfolio might lose value just as the investor needs to rely on it. It is a real-world consequence of stock market volatility. It may be especially concerning for those in or nearing retirement. Investors can, however, plan for sequence of returns risk. There may also be ways to reduce its severity.

Stages of Retirement Planning

There are two stages of retirement planning: accumulation and distribution. They happen sequentially, one after the other.

Investors accumulate retirement assets using vehicles like 401(k)s, the government-sponsored Thrift Savings Plan (TSP), or Individual Retirement Arrangements (IRAs). Some investors contribute to these types of accounts throughout their working lives.

Then they retire.

Many people rely on their 401(k), TSP, or IRA to finance retirement living expenses. This is the distribution stage of retirement planning.

Sequence of Returns During the Accumulation Stage

Two characteristics of common stocks may make them suitable to finance retirement goals, which for many may be decades away.

1) Stocks have historically provided higher rates of return than other investments.ⁱ

2) This higher return occurred (on average) over long time horizons.

The chart above illustrates the return of the S&P 500 from January 1, 1990 to December 31, 2022. During this period, the Compound Annual Growth Rate (CAGR) of the S&P 500 was 10.79 percent, not including dividends.

Now, it’s important to note that this example is offered for illustration purposes only. Investors can’t actually own an index, and of course, past performance is no guarantee of future results. The CAGR noted here does not include any fees or commissions, which would have decreased an investor’s net return.

What the chart demonstrates is that over the long-term average returns have helped to soften the blow of short-term volatility.

Timing and volatility are at the heart of sequence of returns risk.

Investors in the accumulation stage typically benefit from a long-term perspective. That’s why attempts to time periodic market cycles (peaks and troughs) are generally considered futile. But timing shifts in asset allocation may be fruitful for some investors – especially those at or near retirement.

Sequence of Returns Risk and Retirement Planning

Common stock investors at or near the distribution stage may not benefit from a long-term perspective. For them, sequence of returns risk may be a more immediate concern. A big loss right when someone stops working could put future consumption goals at risk.

Contemplating sequence of returns risk early in a retirement plan might make sense. The shift from accumulation to distribution may happen precisely at retirement. But an investor can plan for this precise moment. For some that might be the whole point: to prepare for the day they flip the switch.

This might mean gradually transitioning a portfolio from a growth mode to an income mode. It may take many steps, each one adjusting asset allocation.

Asset Allocation and the Risk/Return Tradeoff

Different asset classes (stocks, bonds, etc.) have exhibited relatively predictable ranges of risk and return over time. Asset mix is important in estimating a portfolio’s future value and is the primary driver of portfolio risk and return.ⁱⁱ

Altering a portfolio’s asset allocation will change its risk/return profile. For example, a shift from all stocks to a mix of stocks and bonds will likely lower a portfolio’s expected return. As a portfolio’s allocation to bonds increases (relative to stocks), its expected return is predicted to decline.

Importantly, this same shift in asset allocation would also likely lead to a decline in the portfolio’s level of risk. A lower allocation to stocks reduces the portfolio’s exposure to stock market volatility. This may decrease exposure to sequence of returns risk.

Asset Allocation and Future Consumption Goals

The graph below illustrates a hypothetical shift in asset allocation over time. A shift like this might be effected along a predetermined schedule as one nears retirement.

It’s important to note that this is for illustrative purposes only. It’s not a recommendation. Investors should seek advice from qualified financial experts regarding their particular circumstances before adopting any strategy.

The appropriateness of this particular strategy would be determined by the investor’s future consumption goals and the portfolio’s estimated future value, which would considers its current balance, projected contributions and the portfolio’s expected return.

Since changes in asset allocation affect expected return, the desire to reduce sequence of returns risk is probably best considered in the context of a holistic financial plan.

Consult your Retirement Plan Advisor to learn more about the key milestones in your retirement planning journey.

¹ Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, Alan M Taylor, (2019), The Rate of Return on Everything, 1870–2015, The Quarterly Journal of Economics, Oxford University Press, vol. 134(3), pages 1225-1298.
² Roger G. Ibbotson & Paul D. Kaplan, (2020) Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?, Financial Analysts Journal, 56:1, Pgs. 26-33, January 2, 2019.

Successful retirement planning may be aided by an understanding of the rules governing qualified accounts, like 401(k)s and IRAs. There are rules for both the accumulation phase and the distribution phase – each of which may offer planning opportunities. Here are some key milestones to consider in the retirement planning process.

Phases of Retirement Planning

The two phases of retirement planning include an accumulation phase and a distribution phase. There are rules governing each phase. These rules define specific milestones that may be considered in an investor’s retirement plan. They include:

1. What happens at age 50
2. What to consider at age 55
3. What ends at age 59½
4. The Social Security decision between ages 62 and 70
5. What begins at age 73

What happens at age 50

All qualified plans have annual contribution limits. Many provide an increased – or “catch-up” – contribution provision for investors who reach age 50.^[1]

The catch-up contribution is an additional amount that can be added to a retirement plan over and above the typical annual limit. These excess contributions are voluntary and may be used by investors to make up for previously missed contributions.

Catch-up contributions may also be used to accumulate additional assets in tax-deferred accounts or to reduce taxable income by the amount of the contribution.

What to consider at age 55

The Internal Revenue Service (IRS) recognizes that some people leave (or lose) their jobs before they actually intend to retire. Sometimes, this might compel them to take early distributions from their 401(k)s.

Participants in company sponsored retirement plans who leave their employers (for any reason) the year they reach age 55 or later can withdrawal funds from those plans without triggering early withdrawal penalties. This is referred to as the IRS rule of 55.^[2]

Rule 55 distributions are not subject to a penalty. But they are considered taxable income, subject to mandatory withholding.^[3] They apply only to a person’s last employer.

Distributions from other previous employers’ plans taken at age 55 would generally be subject to early withdrawal penalties.

The rule of 55 does not preclude a person from starting a new job.

What ends at age 59½

Qualified accounts like 401(k) plans and IRAs are designed to be long-term savings vehicles. The rules governing them are intended to discourage withdrawals before “retirement.”

Early withdrawals from retirement accounts are subject to a 10% penalty. Those penalties don’t apply after a person reaches age 59½, but taxes still do.

Regardless of age, all distributions from an IRA or a 401(k) not transferred directly into another qualified plan are considered taxable income. Such withdrawals are subject to mandatory withholding.

The Social Security decision between ages 62 and 70

Social Security is available to people starting at age 62, but the benefit will not be the full amount. Benefits received at age 62 are paid at a reduced rate. Full Social Security benefits are paid when someone attains “full retirement age” (FRA).

People born before 1954 reached FRA at age 65. Those born between 1955 and 1959 attain FRA in a month between their 66^th and 67^th birthdays. For people born in 1960 or later, FRA is 67.

Delaying Social Security beyond FRA increases a person’s benefits. Those increases end at age 70.

What begins at age 73

Assets held in retirement accounts must start to be withdrawn beginning the year a person reaches age 73. These withdrawals are called Required Minimum Distributions (RMD)s. Prior to 2023, the beginning age for RMDs was 72.

Reaching age 73 is the trigger for RMDs. People are permitted to delay the first distribution. They can wait until the year after their 73^rd birthday.

A person’s first RMD must be taken by April 1^st the year after attaining the age of 73. After that, RMDs must be made every year by December 31^st.

Here are examples of how this works.

The table above shows that people reaching age 73 in any month in 2023 must have taken their first RMD by April 1, 2023.^[4] They were subject to prior RMD rules.

By contrast, people who turn 73 in any month in 2024 must take their first RMD by April 1, 2025.

Under the new rules, the first RMD can be delayed. After that, all RMDs must be made by December 31^st in each subsequent year.

The penalty for missing an RMD is 25 percent. This also applies to any shortfalls. If the entire RMD amount is not withdrawn by the due date, the penalty is imposed on the difference between the required minimum and the amount actually withdrawn.

While errors or omissions corrected within two years may reduce the penalty to 10 percent, missing an RMD can be an expensive mistake.

Consult your Retirement Plan Advisor to learn more about the key milestones in your retirement planning journey.

^[1] Catch-up contributions apply to IRAs, 401(k)s, 403(b)s, 457(b)s, SARSEPs, SIMPLE-401(k)s and SIMPLE-IRAs. Source: Internal Revenue Service.

^[2] The rule of 55 applies only to workplace plans. It excludes all forms of IRAs. A plan administrator may impose specific rules for how distributions may be taken. Source: Internal Revenue Service.

^[3] Distributions paid directly to a plan participant are subject to mandatory withholding of 20 percent. Source: Internal Revenue Service.

^[4] Taxpayers who reached age 73 in 2023 were subject to the age 72 RMD rules in effect for 2022. Source: Internal Revenue Service.

The SECURE Act 2.0 made a significant change to 529 education savings plan accounts. It created a new incentive to use them because it makes funds in the accounts easier to access. Beneficiaries will ultimately be able to take tax free distributions from 529 plan accounts – even if the money is not used for education. But first, the assets must be converted to a Roth IRA.

What SECURE Act 2.0 Changed

The SECURE Act 2.0 builds on the 2019 Setting Every Community Up for Retirement Enhancement (SECURE) Act, which changed many retirement savings rules. The SECURE Act 2.0 included specific changes to 529 plan accounts.

These changes go into effect in 2024 and provide 529 plan beneficiaries with a clear path to tax- and penalty-free withdrawals from those accounts. They also make it possible for 529 plan accounts to be used for retirement planning.

The SECURE Act 2.0 addresses three practical questions for beneficiaries of 529 plan accounts:
 

1. How funds can be used
2. How funds can be accessed
3. When funds can be accessed

How 529 Plan Funds can be Used

Since their beginning, 529 plan accounts have helped people earn tax-free returns on amounts saved to pay qualified education expenses. That hasn’t changed.

What changes is the opportunity to use a 529 plan account to finance a beneficiary’s retirement. The law makes it possible to convert a 529 plan account to a retirement account. This is the case if:

• funds remain after an account has been used to finance a beneficiary’s education
• funds in an account had never been used to pay education expenses

How 529 Plan Funds can be Accessed

Access to funds in a 529 plan account is available after the 529 plan account owner takes specific steps.

The first step is that distributions from a 529 plan account must be transferred directly into a Roth IRA owned by the 529 plan account beneficiary.¹

The second is that those distributions cannot exceed the applicable annual IRA contribution limit (aggregating all accounts) for that beneficiary in any given year. So large balances in a 529 plan may have to be transferred to a Roth IRA in stages.

The SECURE Act 2.0 also caps the total amount that can be transferred from a 529 plan account into a Roth IRA. The lifetime limit is $35,000.

When 529 Plan Funds can be Accessed

Assets may be transferred to a Roth IRA only from 529 plan accounts that have been in existence at least 15 years.

Funds may only be transferred five years after being contributed to (or earned in) a 529 plan account. As such, the account owner needs to keep track of the timing and amount of contributions and earnings.

Benefits for 529 Plan Owners and Beneficiaries

The SECURE Act 2.0 doesn’t change any of the benefits of 529 plan accounts. It helps expand their usefulness. A 529 plan account may ultimately be used to finance objectives beyond education.

This is because:

• Transfers to a Roth IRA are tax and penalty free
• Assets in a Roth IRA grow tax free
• Transfers from a 529 plan to a Roth IRA can be withdrawn immediately
• Withdrawals from a Roth IRA are tax and penalty free

The SECURE Act 2.0 helps to remove many of the obstacles that lead people to delay or decline funding education savings plan accounts. It may actually help families pay for their loved one’s educations while also contributing to their retirement savings.

Working with experienced financial professionals can help you stay the course. They can provide guidance and encouragement to help focus your attention on your long-term goals.

¹Consolidated Appropriations Act, 2023, Section 126