E24: Interest hikes like the 80’s? The Power of Tax Deferral

Executive Summary

Interest hikes like the 80’s? Power of Tax Deferral and the $400k mistake you may be making!

In this episode, Tyler breaks down the tough task ahead of the fed when it comes to interest rate hikes and inflation. Additionally, he examines the power of tax deferral and a 400k mistake you might be making.

Inflation

If you have filled up your car or made a grocery run lately, you are probably very aware that prices have skyrocketed. We have covered some of the reasons for this in past episodes but how do we fix it? Well, the best way for the fed to control inflation is to raise interest rates. Let’s break down why that is the case. When the pandemic hit, the fed dropped interest rates to historic lows. This was to make money very accessible and cheap within the economic system and help keep the economy moving through shutdowns and disruptions. Essentially, the fed wanted to flood the economy with money. When that happens, inflation can begin to pick up and we started to see that happening in 2021. To help control the problem the fed can reverse the process and raise rates to make money harder to access and more expensive to borrow. This will reduce the amount of money in the economy and help drag down inflation.

We have seen the fed do this many times throughout its history but one of the closest comparisons would be in the late 70’s. We saw a large uptick in inflation and the fed took a policy to reign it in by persistently raising interest rates until it was under control. This policy led rates to hit a high of 20%! While it did end up reducing inflation, the contraction on the economy lead to the recession of 81’ and 82’. This is the big problem that the fed is up against today. They need to raise rates fast enough to make sure inflation does not get out of control but not so fast or aggressively that they push the economy into a recession. Right now everyone wants inflation to come back down to earth, but they don’t want the economy to stall or the market to fall…. Unfortunately, those two things work against each other. Let’s hope that the fed has learned the lessons from the 70’s and can land this plane softly. However, the task is going to be incredibly difficult to accomplish.

Tax Deferral

Why is tax deferral so important? Well, let’s start with what tax deferral is – Tax deferral is when you invest in a qualified account (think of your 401k) where any gains in the account are not taxed until you take money out down the road. This means any interest, dividends or capital gains do not receive any taxation in the year they happen but instead is deferred until the money is withdrawn.

If we take two investors and have them invest 100k earning an average of 8% for 20 years into a taxable account and a deferred account, we will see that the deferred account earns 52% more growth than the taxable account. This happens because every year the deferred account allows all the money to remain in the account instead of having to remove some to pay taxes on any gains. That extra money remaining in the account can continue to grow and earn interest and ultimately leave the deferred account in a better position. Understanding the power of this can go a long way to helping you maximize your investment returns!

400k Mistake

Tyler talks about how waiting to invest can have a substantial impact on your long-term plans. To highlight this, we can look at two investors. The first investor puts 6k into a IRA from age 22 to age 32 and stops. Only 10 years of putting money in and earns an average of 8%. The other investor invests 6k a year in an IRA from age 32 to 65. 33 years of contributing money and earning 8%. We will see that when both investors reach the age of 65 that the first investor who only contributed for 10 years has 400k more in their account than the investor who contributed for 33 years. How? Well, the first investor had the benefit of time on their side and while they were not contributing after age 32, the money was able to grow for 43 years instead of the 33 years for the second investor. Compounding interest will favor time in the market! If you are considering investing, know that every day you wait could be costing you big time!

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

Tyler Hafford:
Welcome to financial discretion advisor. I am Tyler Hafford. It’s been a little while since I’ve hopped on the mic. I want to apologize for regular listeners, but I want to talk about a few things today. One big thing we keep hearing about, and I know I’ve done podcasts in the past where I’ve touched on this, but I want to talk about what raising rates really means for us. I want to put in some historical context about how things went back in the 70s and 80s, when we were trying to deal with inflation raising rates and what that looked like, what the Fed is trying to do right now, which I think is pretty difficult. And then again, how it’s going to impact you in your everyday life.

Tyler Hafford:
Additionally, we want to talk about the power of tax deferred growth and what procrastinating starting your investment strategy can cost you. So what’s the cost of waiting till tomorrow for something that you could probably start up today. So just getting into raising rates. So we’re talking about inflation right now is 8% or more, food prices are up, energy prices are up, housing prices are up, car prices are up. We’ve seen this big pickup in inflation. So let’s talk about what the Fed is trying to do by raising rates to control that. Essentially by raising rates, we make borrowing money more expensive, which encourages folks to stop borrowing money and to save more. And it slows the economy down. By doing that, we can start to slow down this inflationary problem.

Tyler Hafford:
So back in the late 1970s, inflation was picking up. And for a few reasons that are very similar today. So they had the oil crisis in the 70s, overspending. Stop me if this is starting to sound like things that we’re dealing with now, where we have increasing energy prices, we have a war in Eastern Europe with a major oil producing nation, which is causing supply issues and prices to go up. And we have come out of a period where we have spent a ton of money. The pandemic hit and we had three different stimulus bills to help rescue the economy. And I would argue that those bills did do that. But the side effect is we had to print a lot of money and put it out in circulation which creates inflationary impacts and pressures on us.

Tyler Hafford:
But we get to the late 1970s, the Fed is saying, all right, we’re going to raise rates and we’re going to push through until we get inflation under control. And in 1980, rates got up to 20%, extremely high. And there were calls to loosen the monetary policy. All right, we can’t tighten things this much. The Fed persisted. They continued to raise rates. And what we saw is that, that strategy did bring inflation down. 1980, 1982 inflation fell to 5%, but the problem was it also stalled the economy and pushed us into a recession in 1981 and 1982. So by slowing the economy down dramatically, which is what happened in the 80s, it almost induced this recession.

Tyler Hafford:
Now, the Fed today has a very difficult task ahead of them. We spent a lot of money, we have a lot of supply chain issues, and energy prices are high. To fight inflation, we got to start pushing those rates. They are being a little flexible about this. So in the 80s it was just a persistent push ahead. What we saw is that after the invasion of Ukraine by Russia, the Fed backed off a bit on their first rate hike. They were supposed to increase the Fed rate by half a percent. They only did a quarter. But they added an extra hike into the plan down the road. So we went from five rate hikes this year to six. The idea is to get us back up close to 1%. Pre pandemic, we were about 1.5%.

Tyler Hafford:
So still historically low, but they have this challenge out of them where if they raise rates too fast and too aggressively, they’re going to dramatically stall the economy, similar to what we saw in the 80s. But folks are crying about inflation. This is something that’s impacting Americans and their wallets quite a bit. I think I saw just the other day that the average household will spend an extra $300 a month to deal with these pickups and prices. So that creates a problem. But raising rates slows down the economy. It also hurts the stock market. We see anytime they talk about rate hikes, so they change the plan, all this starting the beginning of this year, which initially caused the market drawdown that we’re seeing right now is caused by rate hikes.

Tyler Hafford:
So the Fed has this tricky soft landing that they’re looking for. They don’t want it to be as dramatic as the 80s. They don’t want to push us into a recession, but they also need to be raising rates at a fast enough rate to actually control inflation before it runs away on them. So then this really tough spot of doing this. So right now, as of the end of March, it looks like we’re going to see five more rate hikes. We’re going to see another one in May. It sounds like that’s probably going to be a half-a-point rate height. We will see how that strategy changes and what’s happening in Europe and how that impacts it. We are seeing high energy prices right now. And the US is talking about releasing a number of reserves, picking up domestic production, having OPEC pour more oil into the market, and hopefully easing the pickup and prices in energy. That should have some impact on inflation as a whole. As energy picks up, the prices of everything else follows suit.

Tyler Hafford:
So what does that mean for you? What do rates going mean for you? Hopefully, it means inflation coming back down, but there are a few other things going on. Anyone who’s using a high yield savings account, pre-pandemic, probably getting a pretty good rate of return on that, then pandemic hits, rates fall to all-time low so they can help rescue the economy, make a loose money environment where it’s easy to borrow and money is cheap. And those rates on those savings accounts fell dramatically. Well, as rates start to move back up, it’s going to encourage folks to start saving. Remember, we’re trying to tighten the economy. We’re trying to tighten the money supply. By doing that, savings rates go back up. People are now more apt to put money away because they’re saving at higher rates than they were. So that’s a good thing for anyone who is a saver and wants to get some money, get those rates back.

Tyler Hafford:
Remember the reason why that’s happening though, is that we are trying to slow the economy down and tighten the money supply. So individually you get some better rates, but remember that the Fed doesn’t want to do this too much. You don’t want extremely high savings rates, because that probably means that they’re trying to put the brakes on the economy. Mortgage rates are going to start climbing and already have started to climb. So anyone who’s looking to refinance or purchase a home, expects those rates to continue to move up as the Fed increases the interest rates.

Tyler Hafford:
So what does that mean? Well, it could pause mean a slow down in the housing market. A lot of folks who are borrowing money, especially new home buyers are now going to have a decision to make because housing prices are so high that borrowing money, going from 3% to 6% can be something like a four or $500 a month swing. That can be a difference-maker for someone who’s looking to buy right now and deciding that, geez, I can’t afford it. So mortgage rates go up, which may have an impact on the housing market. We will see how much demand is still there as those rates start to creep up.

Tyler Hafford:
Small business impacts. So a majority or a large number of small business owners tend to use credit cards for their business accounts. And credit cards are very sensitive to interest rate hikes. And as those creep up, the interests owed on the credit card tend to move up with it. So small business impact means slower growth because they can’t borrow money as cheaply as they could last year. So that slows down the growth of business. That’s what the intention is or that’s the side effect of raising rates is we’re going to slow the economy down. That is why it’s because borrowing money gets more expensive.

Tyler Hafford:
Additionally, credit card rates. So this is something that’s going to hit home. If you’re holding a credit card balance and rates are going up, again, the interest rate on your credit cards are going to creep up and is going to be more expensive to hold that balance than it would’ve been a year ago. Another good reason why, if you have the ability to pay off that debt to make that a priority before rates continue to move up even further. Additionally, if you don’t need to take on credit card debt, obviously I wouldn’t advise taking on more and more expensive consumer debt, especially with rates going back up.

Tyler Hafford:
So all of these things in play, it’s going to affect us at home, is going to slow down the economy a bit. The Fed is in this really tough zone where they need to control inflation, but they don’t want to bring the economy back to a recession like we saw in ’81 and ’82. Can the Fed do that? We’ll have to wait and see, but I think they are showing some flexibility as shown by the reduction in how much they were going to raise rates due to the war in Eastern Europe. But they are using the rhetoric that they are going to increase rates as much as they need to, to control inflation. So let’s see if they can have a little bit of a softer landing than what we saw from the Fed in the early 80s.

Tyler Hafford:
Now, next topic I want to talk about is tax deferral. Tax deferral is when you can put money into an investment account, that money stays in the account and grows tax deferred until you pull money out in retirement. So think of your work plan today or a traditional IRA you’re going to put some money in. What’s nice is those are also tax deductible plans. So you’re going to get a tax break today, but you put your money in, it’s going to grow in that account and you’re going to take it out in retirement. That’s when you’re going to pay your taxes on it.

Tyler Hafford:
So why is tax referral so powerful? So let’s take two investors. One is going to invest in a tax-deferred vehicle, one is going to invest in a taxable vehicle. They both make $100,000 initial investment, they’re both going to earn market average 8% return over the next 20 years. What we see is that the tax deferred account will have 52% more growth than the investor who is investing in the taxable account. And the reason for that is even if their income tax percentage stays the same in their working years and when they take it out in retirement, and the reason for that is that the tax deferred account can keep money in that account and not pay it out every year on the growth. So by keeping the money in the account until you out down the road allows more compounding growth on larger sums within the account.

Tyler Hafford:
This gives us more growth opportunity and what we saw in that little example is that you’re going to see 52% more growth than the taxable account. So tax deferred growth is a huge benefit for us. And the reason why I talk about it is you have your work plans, you have a traditional IRA that you can put money into, but a lot of folks will run into this situation where they make too much money to invest in, let’s say a Roth or make contributions into a traditional IRA because they are covered by a plan at work. So if you have a retirement account or retirement plan at work and you’re contributing to that, and your income gets over a certain level, you can’t have a tax deductible contribution into a traditional IRA. That will scare some folks off from using those vehicles, but you can make a non deductible contribution to the IRA. And that contribution will grow tax deferred. You’re not going to get your tax break today, but you are getting tax deferred growth. And just from that example I just showed you, how powerful that can be.

Tyler Hafford:
So that is still a tool you can use, even though you’re not getting the tax break today, because you are going to get it every year that, that money can stay in the account before you need to take it out in retirement. So don’t dismiss tax deferral. That can have a very powerful impact on overall returns over the lifespan of investing.

Tyler Hafford:
And then the last tip I want to bring up to folks is the benefit of starting early in investing versus waiting a little bit. I’m going to give you two different investors, let’s say Martina and Andre. Martina is going to invest $6,000 a year into her IRA from age 22 to 32, she’s going to make 8% return, but she’s only doing from 22 to 32. Andre is going to do $6,000 a year getting 8% return, but he’s deciding I’m going to start at the 32. I’m not going to do anything before that, but I’m going to start at 32 and I’m going to do it all the way out to 65.

Tyler Hafford:
And what we’ll see is that even though Andre went from 32 to 65 doing $6,000 a year, Martina had the benefit of time and compounding interest, even though she only did it for 10 years, 22 to 32. And what we see is Martina is going to end at 65 with $1.3 million in her account and Andre is going to end at 65 with $945,000 in the account. So about a $400,000 swing because Martina started at 22 even though she stops at 32 and Andre goes from 32 to 65, she had the benefit of having significantly those 10 extra years that the account could grow on itself, compounding interest.

Tyler Hafford:
I think Albert Einstein said the eighth greatest wonder of the world is compound interest. Martina had enough time. So when you’re making decisions of do I want to invest today or geez, I’ll just do it next year, I can do it, the cost of waiting till tomorrow gets greater and greater. And I would advise you if you have the ability to start today, start today because the cost can be dramatic. And in the example I just gave you Andre waiting 10 years to get started cost him $400,000. That’s a big difference. And that can be a difference-maker in retirement. Maybe Martina having the extra money because she started early, can now retire on her terms. Andre has to wait a little bit long because he did not hit the goals he had set for his retirement.

Tyler Hafford:
The difference between waiting can be dramatic. And that’s something we call an opportunity cost. So every day that you have a dollar you could invest or you’re going to spend it or keep it in a savings account is what are you giving up, and what you’re giving up is the potential for that money to be making you money over that period of time. So don’t wait for tomorrow. If you have the ability to start investing, start early, start today, waiting tomorrow can cost you quite a bit.

Tyler Hafford:
To wrap things up here, let’s see what happens with the interest rate hikes. Do we have the faith in the Fed to land this plane a little softer than what we’ve seen in the 80s? Or do we have faith that they’re going to be able to reign inflation in before it gets a little bit out of control and we’re forced to take more dramatic action? Only time will tell.

Tyler Hafford:
I want to thank you guys for listening in. Make sure to like, share, find us on Facebook, find us on LinkedIn, click the thumbs up button. Any comments, I’d love to hear them. What are people thinking about interest rate hikes? What are people thinking about inflation and how that’s going to impact us in the short term? Please leave them below. You can find my email on penobscotfa.com. Please feel free to shoot me questions. I love to talk about this stuff, I love to answer anything I can. Thanks guys.

Tyler Hafford:
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. There is no guarantee that the statements, opinions or forecast provided here in will prove to be correct. Thank you.