By James J. Holtzman, CFP^®, Legend Financial Advisors, Inc.^®

Given that U.S. interest rates have been slowly increasing for the past two years, but have stabilized recently, Senior Floating Rate Bank Loans (they are also called Bank Loans or Leveraged Loans) make a lot of sense in the current environment of slowly rising interest rates or for that matter, stable interest rates.  Why?  Because their interest rate coupons, which are variable, adjust upward or downward in conjunction with interest rates rising and falling.  Coupons usually adjust every 30 to 90 days, so at times there may be a slight lag in the interest rate adjustments.

In the immediate future, bank loan funds should perform well.  These vehicles provide steady returns and safety except in recessions.

Senior Floating Rate Bank Loans are relatively shortand intermediate term loans (usually no more than 10 years to maturity) typically made to companies that have below-investment-grade credit ratings.  The loans’ interest rates generally reset based on changes to an interest rate benchmark such as the London Interbank Offered Rate (LIBOR)—the rate at which banks loan each other money in the London wholesale money market.  This resetting feature will usuallyhelp protect investors from the risk of rising interest rates. 

In addition, investors, as holders of such loans, have a higher priority claim (“seniority”) on a borrower’s cash flows or assets than holders of conventional bonds.  This means that if a company defaults on its loan obligations, and declares bankruptcy, these investors are higher on the list of creditors to be paid back.  Hence, these are called senior loans.  Finally, such bank loans are usually backed by collateralsuch as real estate, manufacturing plants, equipment, etc., which can help lenders recover up to all of their loans’ value in the event of a default.

Since Senior Floating Rate Bank Loans are typically made to companies whose credit rating is below investment-grade and carry relatively high credit risk, investors are paid a premium over the interest rate, or “yield” they would receive if they invested in higher rated bonds.  This additional yield is provided to compensate investors for assuming a higher risk of default.

For a fixed-rate instrument like a conventional bond, the coupon rate does not change during the life of the bond, so a rise in prevailing interest rates can lower the value of the bond.  For floating rate loans, the coupon rate is not fixed; it floats, as mentioned earlier,.  Therefore, if the benchmark interest rate rises, the yield of a floating rate loan will reset accordingly, helping to preserve the value of the investment and allowing investors to benefit from higher interest rates.  Since the market price of a loan plays a muted role in floating rate instruments, they tend to be less volatile on a day-to-day basis.  Additionally, since interest rates have historically tended to rise in periods of rising inflation, investing in loans that are tied to benchmark interest rates may help offset the effects of inflation.

While all investments carry some degree of risk, Senior Floating Rate Bank Loans involve specific risks, (explained below), which investors should understand how the loans workbefore investing.

Credit risk is the risk that the borrower will default on its obligation to pay interest and repay principal.  If a borrower defaults,a lender may lose money.  If the borrower has posted collateral, loan issuers can seize and liquidate the collateral to recoup their investments.  It is important to note that such collateral may be insufficient to pay the lender back completely, or could prove difficult to liquidate.  Additionally, the courts may, in some cases, prevent liquidation of assets to satisfy debt obligations.

Another key difference between traditional bonds and senior floating rate bank loans is that when interest rates fall, prices of already-issued fixed rate debt securities (like bonds) generally rise, and vice versa.  Due to the fact that interest rates on bank loans fluctuate,interest rate risk is not really of concern to bank loan investors.  If interest rates fall (or rise), yields on bank loans will also fall (or rise), and there will typically be a more modest change or no change in the price of the loans.  Senior Floating Rate Bank Loans’interest rates may not correlate to prevailing interest rates between the loans’ adjustment periods.  That may cause the value of the loans to decline in the short run until the coupons adjust.

Though bank loans are not subject to the same interest rate risks as conventional bonds, the prices of loans may fluctuate due to “spread” risk.  Spreads, which are determined by the market, are the additional interest rate premiums investors receive (versus a risk-free rate such as U.S. Treasuries) as compensation for assuming credit risk.  If spreads change, the price of the loan will also change and the investor’s return will reflect current market rates.

Senior Floating Rate Bank Loans, of course, are not insured by the Federal Deposit Insurance Corporation (FDIC), or any other entity.  Consequently, their value will fluctuate over time, and investors could lose principal.

In an environment of rising rates and inflation, owning Senior Floating Rate Bank Loans may help protect investors’ purchasing power—keep up with inflation(since such loans pay more income as interest rates rise), while seeking to maintain stable prices.

While interest rates may rise for these types of loans, they may increase to a point probably over 10.0% where some companies will begin defaulting on the loans.  In short, interest rates that are too high on these loan types may be dangerous to investors’ capital.

COPYRIGHT 2019 LEGEND FINANCIAL ADVISORS, INC.^®

REPRINTED WITH PERMISSION OF LEGEND FINANCIAL ADVISORS, INC.^®

The Baby Boomer's Guide to Social Security

The Tax Cuts and Jobs Act (TCJA) gives business owners new ways to save significantly on federal income taxes, but there are obstacles to getting the full benefits. Listed below is a primer on tactics to get around some of the barriers.

TCJA permits business owners to deduct 20.0% of the income passed to them through an S-Corp, LLC, sole proprietorship, and other business forms — excluding C-Corporations.  Section 199A of the tax code makes it harder to qualify for the 20.0% deduction for businesses that perform services, such as healthcare, law, accounting or consulting.  For them, the deduction was phased out above $157,500.00 for an individual filer and $315,000.00 for a married couple in 2018, and that will be adjusted for inflation in 2019 (to $160,700.00 for a single, $321,400.00 for a couple).  The deduction was entirely eliminated for a single-filer on taxable income of more than $207,500.00 in 2018 and for married taxpayers with more than $415,000.00 (rising to $210,700.00 and $421,400.00 for 2019).  Earning more than that means you can't take any 199A deduction whatsoever.

How can service-business owners avoid such impediments?  By whittling income down below the thresholds.

As an example, let's take Lisa, a dentist, whose profession is definitely in the service business.  Her husband contributes no income, as he is retired. She receives $400,000.00 in pass-through income from her practice, the profit after she meets all her overhead.  Beyond her pass-through income, she pays herself a salary of $150,000.00. So, her taxable income ($550,000.00, adding the pass-through and the salary money) exceeds the $410,000.00 ceiling — with the result that she is not eligible for the 20.0% deduction.

However, Lisa can make moves to lower her reported income.  First, she can start her own defined contribution plan for herself and her employees — a receptionist, hygienist, and bookkeeper.  That usually means establishing a 401(k) Retirement Plan in her business qualified under the tax code and it would involve research, services and liability to a business owner as well as added costs.

Since Lisa is 55 years old, she can contribute a maximum $25,000.00 yearly to the plan — the standard $19,000.00 maximum contribution, plus a $6,000.00 additional contribution permitted those over 50 years old to encourage them to catch-up on retirement savings, and that would reduce her taxable income to $525,000.00.

Lisa also can open a Defined Benefit Plan for herself and employees.  This is a traditional type of Pension Plan qualified under the tax code to allow participants and their beneficiaries an annual payment for life based on their earnings and life expectancy.  In Lisa's case, she can contribute up to $150,000.00 annually to a Defined Benefit Plan, as that is the average of her past three years' salary.  That shaves her taxable income to $375,000.00, and she now is below the $415,000 ceiling.

Should she wish to pare it further, perhaps to below $315,500.00 to nab the full 20.0% pass-through tax deduction, Lisa has additional options:  She could also make charitable donations.

For business owners, this is a complex area of tax and financial planning and requires expert advice.  

Legend Financial Advisors, Inc.® (Legend) is not a tax or legal advisor.  It is Legend’s intention to merely present ideas and strategies to readers to discuss with their own tax and legal advisors or preferably with those advisors and in conjunction with Legend’s advisors.

The tax burden of Americans was already among the lowest in the world, even before the tax cut that went into effect at the start of 2018.  But the cost of Social Security, Medicare and borrowing are likely to force the U.S. government to raise tax rates in the years ahead.  As a result, if you're nearing retirement or already retired, that makes this a good time to consider converting a traditional individual retirement account into a Roth IRA.  Here's a short lesson on a long-term tax bracket management strategy to increase tax-efficiency in a retirement portfolio, and it sidesteps a new snag in the Tax Cut And Jobs Act that penalizes widows.

• Analysis from the non-partisan Congressional Budget Office shows the interest on the U.S. debt will become unsustainable in the mid-2020s.
• The $21 trillion U.S. debt surges in the next few years and interest owed on the debt accelerates, along with the risk of default.
• As 2023 nears, running trillion-dollar budget deficits annually becomes increasingly untenable policy, and tax rates are likely to rise.
• With a traditional individual retirement account, taxes on gains reinvested are deferred. An IRA grows with no taxes owed. When you retire, withdrawals are taxed as income.
• A Roth IRA is different. You pay income tax up front and Uncle Sam promises tax-free withdrawals when you're retired.
• Inflation has been low for many years.
• While it is not expected to rise sharply, the real cost of the federal debt would be reduced if inflation rises.
• Many surviving spouses will face a tax penalty after losing a mate under tax brackets enacted by the Tax Cuts And Jobs Act.

For example, a couple with $170,000 of adjusted gross income is in the 24% top bracket, but after one spouse dies the survivor would fall into the 32% bracket.  Retired married couples converting a traditional IRA to a Roth account can avert the widow penalty with proper planning.  Since Roth accounts generate tax-free income, converting to a Roth places a surviving spouse in a lower tax bracket.  For example, a couple with $170,000 of income would convert from a traditional IRA to a Roth IRA, lowering their income to less than $157,500.  If one spouse dies, the survivor would be in the 24% bracket applied to singles with up to $157,500 of income.  Coming up with the cash to pay the one-time conversion tax is not for everyone.  However, converting makes no sense unless you have cash on hand to pay the income tax on withdrawals from your traditional IRA.  Withdrawing a larger amount to pay the taxes usually is a bad idea.  Tax-sensitive investing tactics like this can reduce a tax bill by a material amount all throughout a surviving spouse's lifetime.  But tax-managed investing is complicated.

We evaluate tax planning opportunities for clients.

Please contact us with any questions about your personal situation.

If you think you're no longer allowed to deduct items like charitable donations on your income tax return, think again.

The new tax law doubled the standard deduction, slashing the number of Americans eligible to itemize deductions from 37 million to 16 million.

However, if you are among those who will lose your ability to deduct charitable donations, there is a simple strategy for managing the new limits on charitable giving, and it enables you to continue doing good while doing well for yourself by reducing your tax bill.

The strategy is simple: bunch a few years of donations into a single tax year instead of making them annually.

Rather than report charitable donations on your tax return every year, you bunch two or more years of contributions into a single tax year — enough to boost the charitable total above that year's standard deduction.

Say you're married and you give $10,000 in Year 1, $6,000 in Year 2 and $10,000 in Year 3. Your $26,000 total surmounts the $24,000 eligibility. If you deduct the total donations of $26,000 in Year 3, you can take the standard deduction in Years 1 and 2 and itemize in Year 3.

Instead of giving in dribs and drabs, you will need to plan your giving strategy, but this will allow you to give as much as you used to before the limits without losing the tax benefits.

And if you can plan to make the larger donations in a year when you expect higher income, bunching charitable donations can be even more effective in lowering your tax bill.

We'll be speaking with clients about this in the months ahead because this tactic does take some planning in advance.

If you have any questions about your personal situation, please do not hesitate to give us a call.