Decoding the Fed: Four Key Factors Shaping Market Sentiment on February 29, 2024

This is today's headline news on bartchart.com:

"March 10-year T-notes (ZNH24) this morning are up by +8 ticks, and the 10-year T-note yield is down -3.7 bp at 4.227%. T-notes shook off early losses today and are slightly higher on some Fed-friendly economic news."

Fed-friendly economic news

While the Federal Reserve considers many factors when making monetary policy decisions, there are four key factors that seem to have influenced the market's perception of "Fed-friendly" economic news this morning:

1. Inflation: The January core PCE deflator, a key inflation measure, rose at the slowest pace in 2-3/4 years. This suggests easing price pressures, which aligns with the Fed's goal of price stability.
2. Labor Market: Weekly jobless claims rose more than expected, indicating a potential softening of the labor market. This could be seen as a positive by the Fed, as they are looking to balance inflation control with maintaining full employment. 
3. Purchasing Managers Index (PMI): The January MNI Chicago PMI unexpectedly contracted, signifying slower economic growth. This could be perceived as dovish (accommodative) for the Fed, as it might lead them to be less aggressive in raising interest rates.
4. Pending Home Sales: January pending home sales fell by the most in five months. This suggests a cooling down of the housing market, potentially impacting inflation further.

Important Notes

It's important to note:

• The Fed considers many other factors beyond these four, such as global economic conditions, financial market stability, and potential risks to the economy.
• The market's interpretation of "Fed-friendly" might not always align perfectly with the Fed's actual stance.
• This is just a snapshot of the market's reaction based on the information provided.

For a more comprehensive understanding of the factors influencing the Fed's decision-making, it's crucial to follow their official statements, economic data releases, and expert analysis.

Demystifying the Neutral Rate: A Guide to the Fed's Monetary Policy

The Fed's "neutral" rate, also called the natural rate of interest or r-star , is the theoretical interest rate at which the economy operates at full employment with stable inflation.  The benchmark the Fed uses to direct monetary policy is known as the federal funds rate.

Here's a breakdown of why it matters:

• Monetary Policy Gauge: It acts as a benchmark for the Federal Open Market Committee (FOMC), the group that sets the federal funds rate , to gauge the stance of monetary policy.
• Neither Stimulative nor Restrictive: When the federal funds rate is below the neutral rate, it's considered accommodative , stimulating the economy. Conversely, a rate above the neutral rate is considered restrictive , aiming to slow down economic growth.
• Balancing Growth and Inflation: The Fed tries to maintain the federal funds rate close to the neutral rate to achieve a Goldilocks scenario - sustainable economic growth without excessive inflation .

The neutral interest rate is a crucial concept right now because central banks want to raise rates just enough to tame inflation without triggering a recession. This delicate balance makes the ongoing debate about the neutral rate highly influential. The conclusions of this debate will determine when central banks begin to ease rates and how much tightening is considered enough.

The Crucial Role of the Neutral Rate

Estimating the Neutral Rate:

Determining the exact neutral rate is challenging as it's influenced by various factors, including:

• Productivity growth: Higher growth potentially leads to a higher neutral rate.
• Demographics: An aging population can put downward pressure on the neutral rate.
• Global factors: International economic conditions can also play a role.

Estimating the neutral rate, though imprecise, is crucial for the Fed's policy decisions. Central bankers believe long-term trends like productivity and demographics influence it. Their estimates, initially high (4.25% in 2012), have steadily decreased to 2.5% since 2019.

Latest Update:  Despite projections of inflation reaching the 2% target by 2026, Fed officials' December estimates kept the neutral rate at 2.9%. The topic wasn't discussed in their latest meeting minutes.

Effective Federal Funds Rate Chart (source: St Louis Fed)

Decoding the Difference: Neutral Rate vs. Effective Federal Funds Rate

The neutral rate of interest refers to the real interest rate expected to prevail when the economy is at full strength and inflation is stable. It represents the rate that neither stimulates nor restrains economic growth. 

Here’s why the neutral rate and the actual Effective Federal Funds Rate might differ:

• Neutral Rate:
• The neutral rate is estimated to be around 2.9% in December 2023.
• It’s the rate that balances economic growth without causing inflationary pressures.
• The Federal Reserve aims to set monetary policy close to this neutral rate.
• Effective Federal Funds Rate:
• As of February 23, 2024, the Effective Federal Funds Rate stands at 5.33%.
• This rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight.
• The Federal Reserve uses open market operations to influence this rate.
• Divergence Reasons:
• The actual federal funds rate can diverge from the neutral rate due to various factors:
• Economic Conditions: If the economy is growing too fast or too slow, the Fed adjusts rates accordingly.
• Inflation: If inflation is rising, the Fed may raise rates to cool economic activity.
• Recession Risks: The Fed may temporarily set rates above or below the neutral rate to respond to economic conditions.

In summary, the difference between the neutral rate and the actual federal funds rate reflects the Fed’s efforts to balance economic growth and inflation while adhering to its dual mandate.  

When the federal funds rate is below the neutral rate, it's considered accommodative , stimulating the economy. Conversely, a rate above the neutral rate is considered restrictive, aiming to slow down economic growth.

References

1. Measuring the Natural Rate of Interest - FEDERAL RESERVE BANK of NEW YORK
2. The Fed - Longer-Run Neutral Rates in Major Advanced Economies
3. What’s the Fed’s ‘Neutral’ Rate and Why Does It Matter?
4. Federal Funds Effective Rate

RMDs Explained: Demystifying the Rules and Calculating Your Withdrawals

Key points:

• You can withdraw more than the RMD amount.
• RMD withdrawals are taxed as income.
• Qualified Roth IRA distributions are not counted as Required Minimum Distributions (RMDs).
• Roth conversions  don't fulfill the RMD requirement . ^[4]   You must take your RMD for the year before converting to a Roth IRA.   The RMD amount is considered a taxable distribution and is not eligible for conversion.
• Failing to take RMDs results in a 50%  penalty  ( reduced to 25% by SECURE 2.0 , potentially 10% if corrected within two years).
• Roth IRAs do not require RMDs while the owner is alive.
• A 76-year-old with a $100,000 IRA balance would have an RMD of approximately $4,219.41 in 2024, which is about 4.22% of their account balance.
• Different rules apply to beneficiaries inheriting retirement accounts.

What are RMDs?

Required Minimum Distributions (RMDs) are the minimum amounts you must withdraw from certain retirement accounts each year, starting at age 72 or 73 (see next section). This applies to traditional IRAs, SEP IRAs, SIMPLE IRAs , and most employer-sponsored retirement plans.

Starting Age for RMDs Increased to 73 under SECURE 2.0 Act

Here's a breakdown:

• Previously: Individuals were required to begin taking RMDs from their retirement accounts by April 1 of the year following the year they turned 72.
• Current: Due to the SECURE 2.0 Act , the starting age for RMDs has been increased to 73 for individuals born after December 31, 1949. This means they can delay their first RMD until April 1 of the year following their 73rd birthday.

It's important to note that this change only applies to individuals born after 1949 . Those born in 1949 or earlier are still subject to the old rule of starting RMDs at age 72.

 

Protect Your Retirement: Consider a Roth IRA Conversion Before Tax Rates Rise

Consider this scenario:

• You have a $1 million traditional IRA.
• After 2025 , tax rates in the US might increase significantly . ^[3]

Currently, with a 4.22% RMD (required minimum distribution), your taxable income would increase by roughly:

• $42,200 (based on a $1 million balance)

This increase could push you into a higher tax bracket in the future.

Converting some or all of your IRA to a Roth IRA before 2026 might help you:

• Pay taxes on a potentially lower income now .
• Avoid potentially higher taxes in the future .

Remember, this is a simplified example. Consulting a tax advisor is recommended for personalized advice .

Executive Summary of RMD Information:

Who is affected?

• Owners of traditional IRAs, SEP IRAs, and SIMPLE IRAs.
• Most participants in employer-sponsored retirement plans (exceptions may apply).

When do RMDs start?

• The first RMD is due by April 1 of the year following the year you reach age 72 (73 if born after 1949).
• If you reach 72 in 2022, you have two RMDs in 2023: one by April 1 and another by December 31.

How are RMDs calculated?

• Divide your tax-deferred accounts' balance at the end of the previous year by a life expectancy factor provided by the IRS.

Note: This summary provides a general overview and is not a substitute for professional tax or financial advice. Consult with a qualified professional for specific guidance.  

Understanding RMDs: How to Calculate Your Minimum Withdrawal Amount

Here's a more detailed explanation of how RMDs are calculated:

1. Gather Information:

• Account Balance:   You'll need the fair market value of all your retirement tax-deferred accounts as of December 31st of the previous year.   This information can be obtained from your financial institution or custodian.
• Life Expectancy Factor:  The IRS publishes life expectancy tables in  Publication 590-B : Distributions from Individual Retirement Arrangements (IRAs) .  You'll need to choose the appropriate table based on your situation:
  • Single Life Expectancy Table:  This is used if you are inheriting an IRA (beneficiary).
  • Uniform Lifetime Table:  This is the most common table used by individuals with no spouse younger than them by more than 10 years.
  • Joint and Last Survivor Table:  This is used if you have a spouse younger than you by more than 10 years who is the sole beneficiary of your account.

2. Perform the Calculation:

Once you have the necessary information, use the following formula:

RMD = Account Balance / Life Expectancy Factor

Example:

• Scenario:  Let's say your traditional IRA balance on December 31st,  2023,  is $100, 000,  and you are 76 years old (using the Uniform Lifetime Table).
• Calculation:  According to the IRS tables,  the life expectancy factor for a 76-year-old using the Uniform Lifetime Table is 23. 7.  Therefore,  your RMD for 2024 would be:
  • RMD = $100, 000 /  23. 7  = $4, 219. 41

Important Points:

• The RMD calculation is done  annually ,  and the life expectancy factor changes as you age,  resulting in a potentially lower RMD each year.
• You can find the life expectancy tables and additional information on calculating RMDs on the IRS  website .
• This  is a simplified explanation, and there might be additional factors or exceptions depending on your specific situation. It's always recommended to consult with a qualified financial advisor or tax professional for personalized guidance on calculating and managing your RMDs.

References:

1. IRS Publication 590-B
2. IRS RMD FAQs
3. Preparing for the 2025 Tax Sunset
4. What's ahead for your RMDs

Grow Your Retirement Savings Tax-Free: The Benefits of Roth IRAs

Roth IRA: Key Takeaways

1. Tax-Free Withdrawals:

   • Roth IRAs allow tax-free and penalty-free withdrawals for qualified distributions.
   • Unlike traditional IRAs, where withdrawals are taxed, Roth IRAs offer tax advantages.

2. Contribution Limits:

   • The combined annual contribution limit for traditional and Roth IRAs is $6,500 (or $7,500 if you’re 50 or older).
   • This limit applies to both types of IRAs combined.
   • If you earn $161,000 or more as a single taxpayer, or $240,000 or more as a married-filing-jointly taxpayer, then you can't contribute anything directly to a Roth IRA in the 2024 tax year.

3. Income Limitations:

   • Roth IRA contributions are phased out for higher-income earners.
   • Verify your eligibility based on your modified adjusted gross income (MAGI).

4. No Required Minimum Distributions (RMDs):

   • Unlike traditional IRAs, Roth IRAs have no mandatory withdrawals after a certain age.
   • You can leave funds in your Roth IRA indefinitely if you choose.

5. Conversions from Traditional IRAs:

   • You can convert funds from a traditional IRA to a Roth IRA, but taxes apply to the converted amount.
   • Consider tax implications before making conversions.

6. Recharacterizations:

   • You can recharacterize contributions from traditional IRAs to Roth IRAs within the same year.
   • This allows for tax-free treatment if you change your mind.

7. Age Limit for Contributions:

   • 2020 and later: No age limit for regular contributions to traditional or Roth IRAs.
   • 2019: Individuals aged 70½ or older cannot make regular contributions to traditional IRAs.
8. Deadlines:
• Roth IRA contributions: You can contribute to your Roth IRA for a tax year until the tax filing deadline for that year, including extensions. This means you can potentially contribute to your 2023 Roth IRA until April 15, 2024.
• Roth conversions: Conversions from traditional IRAs to Roth IRAs must be completed by the end of the calendar year. So, to convert funds for the 2023 tax year, the conversion must be completed by December 31, 2023.
9. Earned Income Key to Roth IRA Contributions: 
• To contribute to a Roth IRA, you or your spouse must have earned income (typically W-2 box 1— total earned compensation minus retirement contributions). Your contribution is capped at the lower of your earned income or the annual limit ($6,500/$7,500 in 2023).

10. No Limit on Roth Conversions, But Taxes Apply: Unlike Roth IRA contributions, there is no maximum limit on the amount you can convert from a traditional IRA to a Roth IRA. You can convert your entire traditional IRA balance to a Roth IRA, if you wish. However, it's important to remember that the converted amount will be taxable as income in the year of the conversion.

11. Additional Points:

    • Contributions to Roth IRAs are not tax-deductible.
    • Qualified distributions require holding the account for at least five years and reaching age 59½.
    • Roth IRAs allow contributions even after retirement if you have earned income.

Remember to consult a financial advisor for personalized guidance based on your specific situation. 

Roth IRA Flowchart: Navigating Your Options 

Start: Do you or your spouse have earned income?

Yes:

• Do you have any income restrictions based on your modified adjusted gross income (MAGI)?
  • Yes: Check the IRS guidelines to see if your MAGI exceeds the limits for Roth IRA contributions. If it does, you may not be eligible to contribute this year.
    • Exceeds limits: You may not contribute to a Roth IRA this year. Explore other retirement savings options.
    • Under limits: Proceed to "Contribution Amounts"
  • No: You do not have income restrictions for Roth IRA contributions. Proceed to "Contribution Amounts"

No: You are not eligible to contribute to a Roth IRA.

Contribution Amounts:

• Are you under 50 years old?
  • Yes: The maximum annual contribution for 2024 is $7,000.
  • No: The maximum annual contribution for 2024 is $8,000.

Combined Contribution Limits:

• Do your combined contributions to both traditional and Roth IRAs exceed the annual limit?
  • Yes: You cannot contribute to your Roth IRA this year.
  • No: You can contribute up to the remaining limit based on your age and contribution type (regular or conversion).

Regular Contribution or Conversion:

• Are you contributing new money?
  • Yes: This is a regular contribution, limited by the annual amount and income restrictions (if applicable).
  • No: This is a conversion from a traditional IRA, which may have tax implications. Consult a tax professional.

Taxability of Distributions:

• Did you wait at least 5 years since your first Roth IRA contribution and are you at least 59.5 years old?
  • Yes: Qualified distributions are tax-free and penalty-free.
  • No: Distributions may be taxed and subject to penalties.

Early Withdrawals:

• Did you meet the eligibility requirements for a qualified distribution (5 years + 59.5 years old)?
  • Yes: You can withdraw contributions at any time without taxes or penalties.
  • No: Early withdrawals of earnings may be taxed and subject to a 10% penalty.

Required Distributions:

• Are you over 72 years old?
  • Yes: RMDs are only applicable to traditional IRAs, SEP IRAs, and SIMPLE IRAs. Individuals owning these types of accounts must begin taking minimum withdrawals by April 1st of the year following the year they turn 72 (73 for individuals born after December 31, 2022).
  • No: You are not required to take minimum distributions from either Roth IRA or any of the above-mentioned IRAs.

Eligibility:

• Are you a US citizen or permanent resident with earned income?
  • Yes: You are generally eligible to contribute to a Roth IRA.
  • No: You may not be eligible. Consult a tax professional.

Excess Contributions:

• Did you contribute more than the allowed limit?
  • Yes: You may have to withdraw the excess amount and pay a 6% penalty.
  • No: You are okay.

Traditional IRA Conversions:

• Do you have a traditional IRA?
  • Yes: You can convert funds to a Roth IRA, but taxes may apply. Consult a tax professional.
  • Read [2] to decide if a Roth IRA conversion right for you
  • No: You cannot convert to a Roth IRA.

Improper Conversions:

• Did you convert funds in error?
  • Yes: You may be able to recharacterize the conversion within a specific timeframe. Consult a tax professional.
  • No: You may have to pay taxes and penalties.

Other Contribution Methods:

• No: You cannot contribute in other ways.

Recharacterization:

• Did you contribute to a traditional IRA within the last 60 days?
  • Yes: You may be able to recharacterize it as a Roth IRA contribution. Consult a tax professional.
  • No: You cannot recharacterize.

Disclaimer: This flowchart is for informational purposes only and does not constitute tax or financial advice. Please consult with a qualified professional for specific guidance.

Watch This Before Roth Converting in 2024 (YouTube link)

References

1. Retirement Plan and IRA Required Minimum Distributions FAQs
2. Is a Roth IRA conversion right for you?

Navigating Tax Deductions: Standard vs. Itemized – Pros and Cons

Standard vs. Itemized deductions – Pros and Cons

Key Points to Remember

• You cannot claim both the standard deduction and itemized deductions on the same tax return.
• The standard deduction is always a fixed dollar amount, regardless of your actual expenses.
• Choosing the standard deduction is generally simpler than itemizing, especially if your itemized deductions wouldn't exceed the standard amount.
• Itemizing can be beneficial if your total itemized deductions (such as mortgage interest, state and local taxes, medical expenses, and charitable donations) exceed the standard deduction for your filing status.

For more detailed information and specific calculations based on your situation, consult the IRS website or a tax professional.

Should you itemize or take the standard deduction?

When deciding between the standard deduction and itemized deductions for your 2023 tax returns, it’s essential to consider the trade-offs. Here are some of the key factors to consider when making this decision:

Key Factors:

• Homeownership: Owning a home with mortgage interest and property taxes can make itemizing more beneficial.
• State & Local Taxes: High state and local taxes (including real estate, property, income, and sales taxes) can tip the scales towards itemizing.
• Charitable Donations: Regular, significant contributions can make itemizing valuable.
• Medical Expenses: If you paid more than 7.5% of your adjusted gross income for out-of-pocket medical expenses, you might be able to deduct the amount above 7.5%.
• Federal Disaster Areas: Residents of federally declared disaster areas may have additional itemized deductions.
• Miscellaneous Deductions: Consider any other qualifying itemized deductions like union dues or investment fees.

Remember:

• Calculate your potential deductions to compare with the standard deduction for your filing status.
• The standard deduction has increased significantly in recent years, making itemizing less advantageous for many taxpayers.
• Nearly 90% of taxpayers opt for the standard deduction.
• For 2023, the standard deduction numbers are as follows:
• Single taxpayers: $13,850
• Married taxpayers filing jointly: $27,700
• Heads of household: $20,800
• If you’re 65 or older or blind, you may qualify for even higher standard deduction.
• To itemize, you’ll need to keep detailed records and supporting documentation throughout the year. This includes receipts, acknowledgment letters from charities, and tax documents related to mortgage interest and real estate taxes.

Seek Professional Help:

For complex situations or uncertainty, consult a tax professional to determine the most beneficial approach for your specific circumstances.

Standard Deduction: The Simpler Route to Calculating Your Taxable Income

When you choose the standard deduction on your tax return, calculating your taxable income involves a simplified process compared to itemizing deductions. Here's how it works:

1. Gather your gross income:

This includes all your taxable income throughout the year, such as wages, salaries, interest income, dividends, and self-employment income.

2. Subtract qualified adjustments:

These adjustments reduce your gross income before applying the standard deduction. Examples include contributions to certain retirement accounts, student loan interest paid, and some business expenses for self-employed individuals.  Additional details can be found in the next section.

Adjusted Gross Income (AGI) = gross income – qualified adjustments 

• Gross Income=Total income. Income from all sources of income.
• Qualified Adjustments=Expenses the taxpayer paid for with income that the government deems should not be taxed.

3. Apply the standard deduction:

Subtract the appropriate standard deduction amount based on your filing status (single, married filing jointly, etc.) from your adjusted gross income (AGI). You can find the current year's standard deduction amounts on the IRS website.

4. The result is your taxable income:

This is the amount of income subject to federal income tax after accounting for both qualified adjustments and the standard deduction.

Here's an example:

• Imagine you're a single taxpayer with a gross income of $50,000 and qualified adjustments totaling $5,000.
• The standard deduction for single filers in 2024 is $13,850.
• Calculating your taxable income:
• Adjusted gross income (AGI) = Gross income - Qualified adjustments = $50,000 - $5,000 = $45,000
• Taxable income = AGI - Standard deduction = $45,000 - $13,850 = $31,150

Qualified Adjustments : Reducing Your Taxable Income

Qualified adjustments are specific deductions you can claim before applying the standard deduction on your tax return. This effectively lowers your taxable income, potentially reducing your tax liability.

Here's a deeper dive into qualified adjustments:
1. Contributions to certain retirement accounts:

• Examples include contributions to traditional IRAs, SEP IRAs, SIMPLE IRAs, and qualified retirement plans (such as 401(k) or 403(b)) offered by your employer.
• Contributions to Roth IRAs are not considered adjustments because they are made with after-tax dollars.
• The allowable deduction for these contributions has limits based on your income, filing status, and the type of account.

2. Student loan interest paid:

• You can deduct up to $2,500 of qualified student loan interest paid during the year, regardless of your filing status.
• This deduction applies to interest paid on qualified student loans used to finance higher education at an eligible institution.
• Note that there are income limitations for claiming this deduction in full.

3. Some business expenses for self-employed individuals:

• Self-employed taxpayers can deduct various business expenses, including:
• Health Insurance Premiums
• Home Office Expenses
• Equipment Depreciation
• These deductions help offset business income and accurately reflect the net profit for tax purposes.

Additional Qualified Adjustments:

• Educator Expenses: Certain educator expenses (such as classroom supplies and professional development) can be deducted as qualified adjustments.
• Moving Expenses for Active Duty Military Personnel: If you move due to a military order, you may qualify for this deduction.

Is Your Tax Return Optimized?

Using the standard deduction like most taxpayers? Don't forget

Knowing your potential qualified adjustments is crucial for maximizing your tax deductions and lowering your taxable income. Consult the IRS website or a tax professional for more detailed information and eligibility requirements specific to your situation. 

Remember, tax laws can be complex, and seeking professional advice can help ensure you're taking advantage of all available deductions and credits.