Traditions Wealth Advisors
Kristina Badrak/Brien L. Smith, CFP®
Financial Analyst Intern/Certified Financial Planner
1/26/2024

​Economy
In the fourth quarter of 2024, the U.S. GDP grew by 3.3% marking a modest slowdown while demonstrating economic resilience. Core PCE, which gauges household consumption, rose 2.9% in December, slowing from November's 3.2% and falling below the 3.0% for the first time in the past three years. Conversely, the CPI, tracking urban household expenditures, unexpectedly climbed by 0.3% monthly, lifting the annual inflation rate to 3.4%. This rise in CPI was primarily fueled by escalating costs in essentials such as rent, food, gasoline, and notably, used car prices.

Despite these trends, the PCE remains the Fed policymakers' preferred metric for interest rate decisions, particularly because it accounts for changes in consumer behavior. The current trajectory suggests only a 40% chance of a rate cut in March with many economists predicting one in either April or June due to existing uncertainties. On a different note, the job market remains strong keeping the unemployment rate steadily below 4%, this is mirrored in a 0.4% increase in average hourly earnings and a slight rise in labor force participation to 62.8%. In addition, unemployment claims the week of 20th have increased by 25,000 compared to last week, which recorded the lowest level of claims since September 2022.

The indicators within the job market are at an adequate level of stability and are not adding stress to the economy. Considering all these factors, including robust household spending and market uncertainties, the Fed’s meeting on January 31st will hopefully provide us with some insights into the decision regarding rate cuts in the spring.

Social Security
The Congressional Budget Office warns that by 2033, Social Security trust funds will face insolvency, with projections indicating only 75% coverage of scheduled benefits. This is due to the aging population growing faster than the workforce, decreasing the ratio of workers to Social Security beneficiaries from 5.4 to 1 twenty years ago, to 3.8 to 1 today. According to John Mauldin, addressing the debt crisis requires focusing on Social Security and Medicare reforms or raising middle-class taxes since other reforms are insufficient. Medicare and Social Security's combined long-term unfunded obligations represent 95% of the federal government's total unfunded obligations. Over the next decade, Social Security will add nearly $3 trillion to the national debt. At the moment, one of the popular drafted proposals by legislators is to limit the income cap for those earning over $400,000, thereby closing tax loopholes. With presidential elections on the horizon, the incoming administration's stance will be crucial in shaping the future of these vital programs.

Outlook of the Market
According to BlackRock, stock markets typically experience a “sluggish” first half but stronger second half during presidential election years, with the third quarter often yielding a 6.2% return. In addition, during post-Federal Reserve rate cuts, cash yields usually drop quickly. Additionally, high-yield bonds and small-cap stocks tend to be critical recession predictors, typically experiencing declines ahead of an economic downturn. Within the past month, small-cap stocks, particularly the Russell 2000 Index, outperformed large caps with a 14.0% return, correlating with the 3.3% GDP growth in the 4th quarter, supporting the notion that small caps thrive when GDP slows down. Concerns about an economic downturn, however, should be tempered as the government has the capacity to reduce interest rates, thereby facilitating a smoother, more controlled economic landing if necessary. Moreover, the increasing trend in index fund investments contributes to a well-diversified portfolios, effectively spreading out and mitigating risk.

Sources:
https://www.ssa.gov/policy/docs/ssb/v70n3/v70n3p111.html
https://www.bloomberg.com/news/articles/2024-01-18/us-jobless-claims-plunge-to-187-000-lowest-since-september-2022
https://www.atlantafed.org/cqer/research/gdpnow#:~:text=Latest%20estimate%3A%202.4%20percent%20%2D%2D,from%202.2%20
on%20January%2010
https://www.blackrock.com/us/financial-professionals/insights/student-of-the-market

1. What happens if I give a gift in 2024 when it’s $13.61 million per person  and then the exemption is reduced to something like $7 million later? If I start gifting significant amounts while I'm alive, will this cause problems when the current limits sunset after 2025, or if they are changed sooner?

Under current law there will be no "clawback" of exemption previously used that would cause estate taxes on the extra gifted amount. This would still be the case even if the changes to the exemption amounts are put into effect as of an earlier date. Individuals can also give away money annually up to the current limit, which is $18,000 in 2024, to as many people as they would like before it impacts the lifetime limit.


2. For estate taxes, does it matter what types of accounts I'm leaving to heirs? What if all my money is in a retirement account, like a 401(k), or it's all in a brokerage account or some other type of account? Do I need to start reorganizing how my money is held given the changes ahead?

The federal estate tax applies to the value of all assets that a decedent owns or controls at death, regardless of the type of account in which the asset is held. Another option to consider, is that only assets held in certain types of accounts can be efficiently transferred. For example, retirement accounts, such as 401(k)s or traditional IRAs, cannot be transferred to a third party during the account holder's lifetime without triggering income taxes and possibly penalties.

3. If I'm leaving real estate to my heirs and they aren't going to sell it, do any possible changes in the estate tax matter to me? Would my heirs possibly be hit with a tax bill upon inheriting and have to come up with the cash? Does the same apply for leaving rental property, a family business, or a share in a business?

Any estate tax liability is generally the obligation of the decedent's estate, and not the beneficiaries who will inherit the property. The beneficiaries' plans for the assets are not relevant to the taxation of the inherited asset. The value of all real estate would be included in the decedent's gross estate and could be subject to the estate tax, depending on the aggregate size of the estate. That said, for those in states with an inheritance tax, the beneficiary is typically responsible for paying the tax due. Six states have an inheritance tax: Nebraska, Iowa, Kentucky, Maryland, Pennsylvania, and New Jersey.


4. How should I deal with life insurance and my estate? Will any of that change in 2026?

The death benefit of life insurance is considered part of the decedent's gross estate. However, because an irrevocable trust is a separate and distinct entity for estate tax purposes, the value of a life insurance policy owned by the trust would not be included in the estate of the insured.

5. I haven't touched my estate plan in 10 years and I no longer have an estate attorney or anyone to consult. How often do I need to revisit my plan and can you recommend anyone to help me? How do I even get started with so much in flux with the laws?​

A good practice is to review your estate plan every 3 to 5 years, and potentially more frequently if certain life events intervene, such as:

• A significant change in net worth (including the receipt of an inheritance)
• Change in state of residence
• The birth of a child or grandchild
• Marriage or divorce
• Changes in federal or state laws covering taxes
• Death or change in circumstances of the people named to serve as executor under a will, guardians, trustees under a trust, and agents under powers of attorney

Source: https://www.fidelity.com/learning-center/personal-finance/estate-planning-questions-answered?ccsource=email_weekly_0111_1037578_77_0_CV4

by Denise Appleby, APA, CISP, CRC, CRPS, CRSP

Since the Roth IRA was introduced in 1998, the Roth-versus-traditional-IRA debate has been a hot topic, with various arguments being made for one or the other. A key selling point for those who favor Roth IRAs is that the upfront cost of paying taxes on contributions when they are made will be rewarded with tax-free earnings. But Roth IRA earnings are tax-free only if they are part of a qualified distribution. For interested parties, the question becomes, “How does one know if a Roth IRA distribution is qualified?” And if the distribution isn’t qualified, “What are the tax implications?”

The following two steps can be used to help provide the answers to these questions.

Step 1: Determine if the Roth IRA distribution is qualified. A Roth IRA distribution is qualified if it meets the following two requirements:

1. It occurs at least five years after the owner first funded a Roth IRA. This funding can be with a valid regular Roth IRA contribution or a qualified rollover contribution. A qualified rollover contribution is a conversion from a traditional IRA, SEP IRA, a SIMPLE IRA—providing that the SIMPLE IRA has been funded for at least two years at the time of the conversion, or a rollover of traditional (non-Roth) amounts from an employer-sponsored retirement plan.

2. The distribution is made under any of the following circumstances:

• The Roth IRA owner is at least age 59½ when the distribution is made.
• The Roth IRA owner is disabled as defined by Internal Revenue Section 72(m)(7) when the distribution is made.
• The distribution is made from an inherited Roth IRA.
• The distribution is made for first-time homebuyer purposes—subject to a lifetime limit of $10,000.

A qualified distribution from a Roth IRA is tax-free. When determining whether Five-Year Rule Number One has been met, one must consider the following three key facts about Five-Year Rule Number One:

1. The rule starts with the owner’s first Roth IRA: The five-year period for a qualified Roth IRA distribution starts January 1 of the first year that the Roth IRA owner funded any Roth IRA.

Example: John made a regular Roth IRA contribution in February 2023 for 2022. Making this contribution is the first time John funded a Roth IRA. John converted his traditional IRA to his Roth IRA in 2023. John’s five-year period for determining if he meets Five-Year Rule Number One is January 1, 2022. If John had made the regular Roth IRA contribution for 2023, his five-year period for determining if he meets Five-Year Rule Number One would have started on January 1, 2023.

2. It does not restart.
Example: Susie converted $5,000 to her Roth IRA in 2015. This conversion is her first Roth IRA funding. She withdrew the entire amount, including earnings, in 2016. She no longer has a Roth IRA at this point. Susie started a new Roth IRA in 2023. When Susie takes a distribution from this new Roth IRA, the five-year period for a qualified distribution still starts January 1, 2015, even though the 2015 Roth IRA was fully distributed and closed.

3. A beneficiary inherits a Roth IRA owner’s five-year clock. A distribution from a beneficiary Roth IRA is qualified if it meets Five-Year Rule Number One. The five-year period is inherited from the owner. Using the example of Susie above, if she dies in 2023, the five-year period for her inherited Roth IRA starts January 1, 2015. All of an individual’s Roth IRAs (not including beneficiary Roth IRAs) are aggregated and treated as one to determine if Five-Year Rule Number One is satisfied. No further assessment is needed if a Roth IRA distribution is qualified because the distribution is tax-free; there is no federal income tax, and there is no 10% additional tax (early distribution penalty). If a Roth IRA distribution is nonqualified, then Step 2 must be taken.

Step 2: Apply the ordering rules for nonqualified distributions. A Roth IRA distribution is nonqualified if it does not meet the two requirements above. The ordering rules must be used to determine what portion of a nonqualified distribution is subject to income tax and/or the 10% early distribution penalty. Under the ordering rules, distributions are taken from the following layers of sources in the order listed.

1. Layer 1 consists of regular Roth IRA contributions and rollover of basis amounts from designated Roth accounts. A designated Roth account can be a Roth 401(k), Roth 403(b), or governmental Roth 457(b) account. All an individual’s Roth IRAs (not including beneficiary Roth IRAs) are aggregated and treated as one to determine an individual’s total amount in Layer 1. Distributions from Layer 1 are tax-free.

2. Layer 2 consists of qualified rollover contributions. (See above under Step 1: Determine if the Roth IRA Distribution Is Qualified). Distributions from Layer 2 are tax-free. However, if the distribution occurs before the Roth IRA owner is at least age 59½, it is subject to a 10% early distribution penalty tax unless the distribution qualifies for an exception. One of the exceptions is Five-Year Rule Number Two. Under Five-Year Rule Number Two, the five-year period starts January 1 of the year the qualified rollover contributions are done and applies separately to each year. All of an individual’s qualified rollover contributions (not including rollovers to beneficiary Roth IRAs) are aggregated by year to determine an individual’s total amount in Layer 2.

Example: 45-year-old Tara converted $75,000 from her traditional IRA to her Roth IRA in 2018, and $25,000 from her SEP IRA to her Roth IRA in 2018. This is a total of $100,000 for 2018. Tara also converted $50,000 from her traditional IRA to her Roth IRA in 2023. The $100,000 2018 conversion will be distributed before the $50,000 2023 conversion.

Scenario 1: If Tara distributes the $100,000 in 2023, it will not be subject to the 10% early distribution penalty because it would have been at least five years since it was converted to her Roth IRA.

Scenario 2: If Tara distributes the $100,000 and the $50,000 in 2024, only the $50,000 would be subject to the 10% early distribution penalty because it would not have been at least five years since it (the $50,000) was converted to her Roth IRA. The 10% early distribution penalty would be waived if Tara qualifies for an exception. One would only get to Layer 2 once the entire amount in Layer 1 is distributed.

3. Layer 3 consists of earnings accrued in the Roth IRA and the earnings portion of a nonqualified distribution from a designated Roth account. All of an individual’s Roth IRAs (not including beneficiary Roth IRAs) are aggregated and treated as one for purposes of determining an individual’s total amount in Layer 3. One would only get to Layer 3 once the entire amount in Layer 2 is distributed. The road to tax-free Roth IRA distributions. The goal of saving in a Roth IRA is to get tax-free distributions—including no 10% early distribution penalty. If one cannot wait until one is eligible for a qualified distribution, the next best strategy is to ensure withdrawals consist only of amounts from Layer 1 as those amounts would be tax-free and penalty-free. For Layer 2, one could wait five years to avoid the 10% early distribution penalty on distributions if one is under age 59½ and does not qualify for an exception. For earnings, the only way to avoid income tax is to ensure the distribution is qualified. However, the 10% early distribution penalty can be avoided if one qualifies for an exception.

To find out if your Roth IRA distribution is taxable, please reach out to Brien or Laurie, [email protected] [email protected] or 979-694-9100.