E21: Inflation, Crypto, Backdoor Roth
Executive Summary
In this episode Tyler tackles some of the reasons for the recent rise in inflation, and how it can impact your portfolio. He also dives into the world of Crypto and how it is changing the investing landscape. The financial planning strategy on this week’s episode is the Backdoor Roth.
Inflation: What is it and why are we seeing it now?
Inflation is the rate in which the value of your currency is falling, or on the flip side, the rate in which goods and services are increasing. Right now, we are seeing big increases in things like Food, Energy, Housing and Automobiles…but why?
Spending
We have spent a lot of money in this country since the beginning of the Pandemic, almost more than any other time in US history! When we print a ton of new money and put it into circulation, the value of that money inevitably falls. Now the Fed has signaled that they believe this inflation will be short term or “Transitory” and they will not use their weapon against inflation, raising rates, just yet. When we look at the recent historical comparison of our spending to come out of the great recession, we will see that we never really paid the inflationary price.
Supply Shortages
The pandemic has shown us how fragile the global supply chain is. From people not going to work and entire operations shutting down temporarily to save costs, the system has been turned upside down. On the flip side of that, all the previously mentioned spending has put money in American’s pockets and created a booming demand for almost everything. When the supply levels are so far off from the demand levels we see price increases, and this is exactly what we are seeing today. From all the factors contributing to inflation, this one seems to be the most difficult to overcome.
Employee Leverage
We are living through what is being touted as the “Great Resignation”, as more and more American’s are leaving their jobs. To combat this, employers are offering higher wages and better benefits to either retain current employees or lure in new ones. The more employees need to be paid, the more the goods and services will need to cost. This is a wonderful thing for workers in the United States, but it is adding to this price increases we are seeing across the board.
Crypto: Inflation Hedge? Currency?
Crypto has been all the rage in the headlines, but what is it?
Cryptocurrency is a digital currency that uses a complex method called “Blockchain” to ensure that the digital asset cannot be counterfeited or double spent. Some big money managers have been pointing to Crypto as an inflation hedge instead of the traditional hedges like gold and silver. To their point there has been large run ups in the value of cryptocurrencies like Bitcoin since their inception, and those run ups have easily outpaced inflation 10x over. What investors need to weigh is that with those high returns come high risk. Tyler dives into the extreme volatility of cryptocurrencies like Bitcoin and how that might be holding it back from being a legitimate currency contender.
Backdoor Roth
This episode’s financial strategy is the Backdoor Roth. This isn’t some shady financial technique, instead it is a very legitimate way for high earners to gain access to the tax-free benefits of a Roth IRA.
The Roth is an incredible financial tool but is limited to folks who do not exceed the income limits set by the IRS. This has left high earners out of luck when it comes to having assets that can grow into the future tax free, but there is a solution – the Backdoor Roth! To put the backdoor Roth into action, a high earner would open a traditional IRA and make a non-deductible contribution into that account. They would then make a conversion of that contribution into a Roth IRA and the asset would begin benefiting from tax free growth.
Roth conversions do not have an income limit and you can do one every year. By making the non-deductible contribution into the Traditional IRA, it allows the investor to make the conversion without having to pay taxes (normally the drawback to converting pre-tax contributions in a Traditional IRA to a Roth).
The draw back to this strategy is unlike a normal Roth contribution, the investor would need to wait at least 5 years to touch their principal without being subject to a 10% penalty (unless they are over the age of 59.5). By utilizing a backdoor Roth, high earners can start to build a tax-free asset.
DISCLAIMER: The foregoing content reflects the opinions of Penobscot Financial Advisors and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security.
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Full Transcript
Hey, everyone. Welcome to Financial Discretion Advised, I’m Tyler Hafford, doing it a little differently on this episode, you’ll notice it’s just me. Going to switch up the format going forward. Going to try to tackle some things in the headlines, some current events in the financial world, throw in some financial strategies towards the end of the podcast so we can certainly help everyone improve their financial pictures. Do a bit of round robin of having some experts in. Whether they’re in this firm, advisors or portfolio managers, or finding some outside folks who handle taxes or estate planning, things like that. Try to get the listeners some interesting tidbits and strategies that can help them improve their financial world.
But let’s just dive in to the first topic I have listed here. And it is the one that is taking over the headlines. It is the one that is taking over your wallet. Inflation. I know you can’t turn on TV right now without hearing about it. You’re certainly can’t go to a grocery store and buy anything without feeling it. So let’s dive into what inflation is. I know we’ve done podcasts on this, so please go back and let’s do it. We had our portfolio manager on, Tim Chaplin. He is fantastic. They do a good job breaking down what inflation is.
But inflation essentially is the rate in which your currency value is dropping. And consequently, the rate in which goods and services prices are going up. So yeah, you’re certainly feeling it in a ton of different places. Just some stats here, looking at the end of October, food prices up 5.3%, energy prices up 30%, all items across the board we’re seeing an increase of 6.2%. These are real price increases that are starting to affect Americans. So why is it happening? I think we like to just find something really simple and say, “All right. That’s the cause of what’s happening.”
Inflation right now has a kind of a perfect storm going on and a ton of different factors that are playing into it. So one, we’ve spent a lot of money in this country, it doesn’t matter which side of the aisle you sit on, on this issue, both parties did a ton of spending. Both of the recent presidents signed spending bills to help us get out of the pandemic, help rescue the economy. When we print a ton of money and put it out into circulation, inevitably, the value of that money falls. So, that’s going to have some inflationary impacts.
Now the Fed has leaned on the side of, “All right. We think this is going to be a short-term thing.” Transitory is the word they’re using. “We think inflation is going to be transitory.” The way the Fed fights inflation is raising rates. And they said, “We’re not going to do that right now.” And there probably will be waning from the strain of printing all that extra money. Now, I’m not saying I subscribe to this, but there is a thought out there, a theory, Modern Monetary Theory, which is saying that if you have the global currency, the currency that the rest of the world bases everything off of and you print a ton of money and put it out in circulation. And there is a large demand globally for that currency. And the rest of the world eats it up, it will help mute that inflationary impact.
And a lot of this came out of ’08/’09. We had the great recession, we did spending to get out of that. And we never really had to pay the inflationary price for doing so. And there’s some thought that, “All right. That might be the same case here.” Now what we spent in ’08/’09 doesn’t really compare to what we spent in the past couple years. But that increase in spending is creating some type of inflationary pressures. That may be a short-term thing, it probably will be a short-term thing because of the spending. But certainly a factor in this.
The next factor is one that we’ve all also felt if you’ve tried to order anything in the last year and a half. And it’s the supply chain issues, essentially what happened is during the pandemic companies shut down factories, people weren’t going to work really put a log jam into our supply chain. That was already being a bit strained from things like trade wars, but certainly the pandemic really put this at the forefront, and starting these things back up isn’t like putting a key in a car.
You can’t just say, “All right, we go from not producing and not shipping anything to all right, let’s go back to normal.” Doesn’t happen. This is the old supply and demand. A little bit of my background. I was a political science pre-law major before I smartened up and decided I want to do this for the rest of my life and ended up actually getting some education around it at BU. But I remember when I was a freshman, I had to take an elective, you have to take these different courses. I just picked macroeconomics, didn’t think I was going to do anything in finance in my life. And anyone listening and doesn’t know what they’re going to do with your life, everything changes.
But I remember going in that class, you sit down, the professor outlines, “Hey, you should probably come to class.” He goes over what homework’s going to look like. And then he turns around, he turns a screen on, and it is a supply and demand chart. That’s just where it starts. And if supply is low and demand is high, prices are up. And that’s what we’re seeing right now, demand is booming from the pandemic. All those spending bills essentially put money in Americans’ pockets.
Again, it doesn’t matter what side of the spectrum you sit on this, those bills did what they were supposed to do. They helped the economy through this time period, it helped save tons of small and mid-sized companies in the United States. And I don’t want to belittle this and pretend like there weren’t people and companies that didn’t do well through the pandemic. That’s obvious and you hate to see that happening. But the economy as a whole was able to survive enough of it because of those spending bills.
But what it’s done is allowed Americans to have a high demand for things. And right now, supply is being held up because of a number of factors. Can’t find enough people to come do the job, there’s not enough people who want to or in that business to help with the supply chain. I think I saw something a few months back that there’s about a million more jobs and Americans looking for work. So, that’s causing problems. There’s a ton of logistic problems that are bottling up. And these are freak accidents that I think happen throughout time. We just never really keyed in on them.
Anyone who owns a pool, I remember this summer, beginning of the summer, it was go out and get your chlorine, go get your chlorine. There’s going to be a shortage. Go get your chlorine. That was because there was a fire at the largest plant that produces tablet chlorine in the country. I want to say, Texas. If I’m wrong, I apologize. I think it was in the Southern part of the country. And while that probably happened before this, it’s just highlighting all of these little things that are happening are just compounding on this problem.
Giant supply ship stuck in the Suez Canal, hurricanes that we’ve always dealt with just adding to the problem. So as long as supply is down and demand is high, we’re going to see higher prices. That piece of the puzzle, I think is going to take us a little longer to figure out than the impact of all the spending we’ve done with inflation. As long as that first chart you see when you go into macroeconomics and probably in high school these days when they’re talking about the economy or finances is the supply needs to match the demand. And until that happens, we’re going to see higher prices.
The last … Not the last thing, but another big thing that’s compounding this inflationary problem is employee leverage. So what we’re seeing right now, and you’ve heard the moniker, the Great Resignation. People are just leaving their jobs. And it’s giving employees a lot of leverage in their employer, employee relationship. Employers to attract one, people to come work for them. And two, good people to come work for them, qualified people come work for them, are raising wages. This has a compounding effect because the products that those people are producing then need to go up in price to justify or to take care of the wage increases.
So employee leverage is great and people making more money is fantastic, but it’s just another step in this inflationary process that’s creating pressures on us. The more we have to pay folks, the more the services and the goods cost for if we go back to what inflation is, it is either the value, the money falling, or the increase in the price of goods and services. So all that’s going on, what does this mean for our portfolios? I know what it means for your wallet. You know what it means for your wallet. Things are expensive right now, but what’s it doing to the investments that we have?
We have these portfolios built up, what’s inflation going to do to those investments? Couple of things, diversification is so important. All of the podcasts that we’ve talked about investing, anyone who’s talked to me, diversification is so important for lowering your risk on your investments, but it also makes sure that you’re taking advantage in a variety of scenarios. And what you’re going to see here is I encourage anyone to go into your portfolio right now. Or if you’re driving, wait till you get home, take a look at it tonight, take a look at performance by your asset classes.
So what we’re looking at here is stocks or equities, bonds or fixed income. How was your performance? I bet you that stocks sleeve looks pretty good. Stock markets come roaring back since March of 2020. You know what’s probably not looking very good? The bond section. It’s probably not even keeping up with inflation. We’re see inflation running around five, five and a half percent. That bond sleeve, probably not even keeping up with that. Where’s that a problem? Folks that have a traditional portfolio, stocks versus bonds, you have a 60/40 portfolio, 50/50 portfolio. What it’s doing is that bond, that safer side of your portfolio is not even keeping up with inflation.
And you’re thinking, “All right, Tyler, what am I supposed to do here? Go all stock?” No, that’s extremely risky obviously. We’re building out portfolios to help minimize risk. You find your risk tolerance, where you are in your life and you help build out a portfolio. But if you’re not including another asset sleeve in there, alternative assets, you’re doing yourself a disservice and it’s really paying off right now. But just for overall diversification, it’s extremely important to be building out alternative assets in your portfolio.
What are alternative assets? Alternative assets are things like real estate, commodities, futures contracts, hard metals, those types of … these real assets. When do those do well? High inflationary times. If you did build out a portfolio with stocks, bonds, and alternative assets, I encourage you go back again and look at those performances by your asset class. I bet you stocks did pretty well. I bet you bonds really didn’t do very well. And I bet you alternative asset are somewhere in the middle, giving you a nice yield for putting that in the portfolio.
Again, diversification, diversification, diversification. It will only benefit the portfolio. And right now, anyone who took those steps prior to seeing inflation pickup, reap the benefits of it. So anytime you’re sitting down, whether you’re doing yourself or you’re working with a professional, alternative assets have a place in everyone’s portfolio, or almost everyone. Obviously I don’t know everyone’s situation, but it’s an important thing to have in a portfolio and something you really want to be considering.
Next topic, crypto. I’m not the first one again, like inflation, to be talking about crypto. But I think it’s important to dive into this, what’s going on, because it is being talked about as an inflationary hitch. So it’s still in the news. We’ve been tackling this since Bitcoin showed up years ago. But just real simple. What is crypto? Crypto is a digital currency and I’m going to come back to that, that currency piece. But crypto is, and the crypto part of the currency is the method that they’re using to make sure that the money can’t be counterfeited and it can’t be double spent. That’s really important with currency.
It can’t be counterfeited because you can’t have fakes out there in the market. It’s going to devalue and make the currency worthless. And you can’t double spend it. So people can’t be spending the same Bitcoin on two different sides of the country at the same time. So crypto is taking blockchain essentially, and this is digital method to make sure that your money’s staying secure, can’t be double spent, and it can’t be counterfeited.
Now Bitcoins recently fell in the news and anytime it goes up quite a bit and anytime it falls quite a bit, it makes the headlines. People love or are infatuated with this cryptocurrency craze. Anything that sees a price increase or a value increase like cryptocurrency has, will make the headlines and be something people want to pay attention to. Now inflationary hedge, the thought here is that it’s going to raise in value faster than what inflation’s going to do. And traditionally, what we looked at was gold and silver and things like that, those alternative assets to be inflationary hedges, and that’s where investors would go.
Well now in today’s world, people are starting to flock to cryptocurrency. We’ve seen big run ups. At the end of October Bitcoin on the year up 87%. Gold, down 7.3%. So there’s a bit of a shift in what’s happening here. The difference between those two though is that gold has an actual asset. Bitcoin does not. The risk lies with Bitcoin much more than gold. Now there’s risk with gold. That’s not what I’m saying, there’s risks in everything. But the risk in the cryptocurrency market is high. And anytime you’re seeing high returns, there’s always going to be high risk. It’s the trade off.
Are you willing to take that risk to get the higher return? My two cents on this for whatever it’s worth. And let me put it this way. There’s people out there with a lot more money and know a lot more than I do who are big on crypto. You see Elon Musk talk about it. I think for a time they’re taking payments in crypto. J.PMorgan comes out and says, “We think crypto is better inflationary hedge than gold.” There are big money managers, big into crypto. Not saying that they’re wrong at all. This is my take on why I think the risk is still high for this currency. And I told you I’d come back to that.
So currency is what we’re trading for goods and services. My problem with crypto is that let’s say, I want to buy a boat from you. You’re going to sell me your boat. I’m going to pay you in Bitcoin. I’m going to give you $10,000 worth of Bitcoin. By the time that crypto leaves my digital wallet and goes into yours, there can be so much volatility in that market that the value can drop dramatically. Let’s say that 10,000, by the time you received it was only 4,000. Well, I got a great deal on a boat and you got screwed. I can’t understand where business can transact in this without the stability of the currency.
It can move so quickly. And we’ve seen this in the Bitcoin falling over the past few months or in the past week or so. We saw huge run ups and then we saw pullbacks. Now I understand NFL players are hitting the headlines saying, “I’m just taking my salary in Bitcoin.” I think Aaron Rodgers came out and said, he’s going to take a portion of his in Bitcoin. Again, some companies are talking about transacting in it. To me it can’t be a widespread currency until we have that stability of it. You know the US Dollar. When I give you the Us Dollar, by the time you get it, the value is not going to change dramatically. Bitcoin, it could.
All right. Onto our financial strategy portion of this. Going to try to fit these into every episode, want to tackle something that I think can help a lot of people or something that folks just maybe don’t have a ton of education around. Today, backdoor Roth, now backdoor seems kind of like a sketchy illegal workaround. This is a completely legal way for high earners to get into a Roth IRA. Now we’ve talked about Roth, we’ve talked about traditional in previous podcasts. Just going to recap it really quickly.
A traditional IR, you put your money in today, you get a tax deduction on that contribution today, it’s going to grow tax deferred. And when you take the money out in retirement, you’re going to be taxed at your income rates at that time. The reason why it makes sense. If you’re in a high tax bracket today, you put cash in, you get your tax break when you’re pulling it out. If you’re in retirement, hopefully you’re in a lower tax bracket, ends up working in your favor and also works in the government’s favor because you’ve been saving for retirement and you’re not completely reliant on the social security system.
Roth IRA, take the money you have today. You’ve already paid your taxes on it, you put it into the Roth IRA, it’s going to grow tax free. And if you take it out in retirement, you don’t have to worry about taxation. So paying taxes today, tax free asset going forward. Couple of the big things here, no required minimum distributions on a Roth IRA. There is required minimum distributions on a traditional IRA or your traditional work qualified plan. Requirement of distribution is Uncle Sam coming to you and saying, “All right, we gave you a tax break when you started this thing, but you’re not getting it forever. We’re going to take the value of your account at the end of the year and divide it by a number associated with your age, starting at age 72.”
You have to take that out by December 31st of every year. So if you’re listening to this right now on November, what is it? 17th. And you haven’t taken your requirement distributions. You’re 72, I would start looking into that. You’re going to want to get out before the year end. If you just turn 72 this year, you’ll have till April 1st of next year, anyone else over 72, going to want to take it out by December 31st. If you don’t, what’s left in there, say you had to take 1,000 out. They’re going to tax you at 50%. You’re going to have a 50% penalty for keeping that money in there. So get it out.
So you have those two different types of vehicles. The bummer about the Roth is that if you make too much money, they’re not going to let you use it. So in 2022, they’ve set out new limits. If you are a single earner, if you file single and your modified adjusted gross income is 144,000 or more, can’t contribute into the Roth IRA. If you are married filed jointly, and your adjusted gross income is over 214,000, can’t contribute into the Roth. What they’re doing is they’re giving you this great vehicle to save for retirement. It’s tax free, but they don’t want extremely rich people taking advantage of it in the same fashion that people making under those income levels can take advantage of it.
So how do we get around that? Because having a tax free asset is fantastic. It gives you flexibility in retirement. You don’t care about tax increases in the future. If Congress is talking about it going up, you don’t have to worry about that. If you are looking for another avenue, set money away for retirement outside of your qualified work plan, a Roth IRA is a great tool to do so. So, how do we make this happen? Since you’re making too much money for the Roth. And let’s say you’re an active participant in your work plan. And that’s key for traditional IRA.
So if you’re not an active participant, so you work somewhere and they don’t offer you a work plan or you’re not participating in it. And the company’s not putting any money into it, you can then, doesn’t matter how much money you make. You can open up a traditional IRA, contribute to it and get a tax deduction. Well, let’s say for this scenario, you have a work plan. You’re contributing to it, 401(k), putting your money in, and you have a high salary. You’re a single earner, making $180,000 and you can’t get your modified adjusted gross income under that threshold. What you can do is make a non-deductible contribution to a traditional IRA.
So a non-deductible contribution just like it sounds, you put your money in after you’ve paid your taxes on it. You’re not going to get a tax break there. You’re an active participant in your work plan. You make too much money. You can’t get a tax break, but you can put a non-deductible contribution into that. And you’ve already paid your taxes on it. Every year, you can do a Roth conversion and we’ve done a podcast on this. So go back and listen to the podcast, but I’ll just highlight it. What we’re doing is taking money out of that traditional IRA bucket and converting it into the Roth IRA bucket.
Normally, the way this happens is whatever’s in the traditional IRA, you’ve probably put in pre-tax and it’s been growing tax deferred. So when you do that, you have to pay taxes on what you’ve moved over. It’s going to be taxes income. There’s no penalty for doing it and like I said, you can do it every year and there’s no income limits on that conversion. So it doesn’t matter how much money you make. But if you put a non-deductible, so let’s start from scratch. You open up two accounts. You open up a traditional IRA, you open up a Roth IRA.
You put the non-deductible contribution into the traditional IRA and then convert it to the Roth. You’ve already paid your taxes. So there’s no taxes out on it. You didn’t invest it in the traditional IRA. So there’s no gains to be taxed on. You’ve converted to the Roth, and then it starts growing tax free for you. Now, there are some drawbacks of doing this versus just putting your money into a Roth IRA. You put your money into a Roth IRA and you can contribute to a Roth IRA because your income always can touch principle without taxes or penalty.
So you put 10,000 in, grows 20,000. You can always take 10,000 out without penalty or taxation. Not recommending this. Don’t touch your retirement accounts unless you absolutely need to. It’s a break glass in case of emergency thing. But you always have access to that. When you do a conversion, if you’re under 59 and a half, you have to go five years before you can touch your principal without being penalized on it. They’re not going to tax you. You’ve already paid your taxes. You’re not getting double tax. They are going to hit you with a 10% penalty if you touch it within the first five years, unless you have a qualifying event, which the IRS lists out.
And like I said, if you’re over 59 and a half, that doesn’t apply, but it is a little different than if you were just to directly contribute to a Roth IRA. But what this strategy does is allows high earners to get into a Roth IRA and get some tax free growth and have an asset down the road that you’re not going to have to require minimum distributions out. So couple things, here you can recategorize IRA contributions. They’ll allow you do that. You have to fill out some paperwork. One big one here is if you’re going to do a conversion, be sure you know what you’re doing and you’re good with it because the tax cut and Jobs Act of 2017 ban the strategy of recategorizing Roth to traditional IRAs. So make sure that you’re committed to the conversion, but can be a great way for high earners to get some tax for growth.
That’s all I got for you guys today. Please, please, please fill out any comments or questions. Feel free to email me at thafford@penobscotfa.com. Go to our website, you can find my information. What I want to do every time I host the podcast, hopefully once every couple of weeks, we sit down, talk about what’s going on in the news. Talk about one of these financial strategies. Hopefully get some experts in here to bring some great insight and help. But if I’m getting enough questions, I would love to do a live question and answer or at least tackle some of the things you guys have on your mind. I want to thank you guys for listening. Go out, enjoy Thanksgiving, get your turkeys early. I can promise you, there’ll be some type of shortage. All right. See you guys. Bye.
The foregoing content reflects the opinions of Penobscot Financial Advisors and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any of security. There is no guarantee that the statements, opinions, or forecast provided herein prove to be correct. Thank you.
