Investors with diversified portfolios no doubt noticed that their allocation to bonds did nothing to offset the stock market’s downturn. This is because interest rates skyrocketed from zero to over four percent in a short period of time. The federal funds rates controlled by the Fed began 2022 at 0%–0.25% and shot up to 4.25%–4.50% by year end. Since bond income payments had fallen so low in prior years, there was no income to offset the decline in bond prices driven by rising interest rates. Consequently, the Bloomberg US Aggregate Bond Index ended the year with a negative 13 percent return, its worst return in 97 years.

In the coming months, investors will remain focused on the Federal Reserve and how it will continue to implement its dual mandate of maintaining full employment in the economy while also keeping inflation in check. The Fed has indicated that it is fully committed to bringing inflation back to its long-term target of 2.0%. The challenge is that the Fed may increase rates too much or hold them too high for too long, throwing the economy into recession. This prospect of recession is what the stock market has been wrestling with.

The downturn in stocks suggests that investors expect a recession, or at least a significant slowdown in economic activity. What is unclear is whether that recession is still to come or has already passed. Looking solely at growth in Gross Domestic Product (GDP) which measures US economic output, we see that growth turned negative in the first and second quarters of 2022, but the downturn was mild.

Still, many economists are predicting that the 2022 blip in GDP is not the recession the stock market implicitly forecast when it fell into bear market territory. Rather, they expect a recession to come in 2023 or 2024. True, there are some signs of weakness appearing in measurements of the economy’s health. One key indicator is the fact that short-term interest rates are higher than long-term rates (the inverted yield curve) which is a signal of tightening credit. An inversion in the yield curve has preceded all recent recessions. However, in today’s post-pandemic environment, there are reasons to suspect that this relationship may not hold. Specifically, the labor market remains strong, and inflation appears to be coming down rapidly, perhaps enough to throw the inverted yield curve recession signal off. Recent monthly inflation readings have fallen closer to the Fed’s two percent target.

With inflation easing, it is reasonable to expect that the economy may avoid a recession. Even economists who are forecasting a downturn expect a brief and shallow decline in employment and economic activity. In the stock and bond markets, what we can expect in the near term is an environment in which bad news is good news. That is, any signs of weakness in the labor market or GDP may cause stock prices to go up in anticipation that the Fed can stop raising interest rates and eventually take them in the opposite direction. Continued declines in inflation readings can be expected to have the same effect. While the Fed is currently expecting the federal funds rate to close at 5% in 2023, an improving inflation picture makes this scenario unlikely.

​In turn, there is reason to be optimistic for both stock and bond returns. Stocks, as they are prone to do, will likely turn positive well before the specter of an impending recession disappears, providing solid gains to investors who were able to stay invested while things were less certain. Bond investors will benefit from higher income yields while rates remain high and might even expect capital appreciation when the Fed eventually does pivot back to reducing rates instead of raising them.

The benefit comes in the tax advantage. While these accounts are funded with after-tax dollars (there is no up-front tax deduction for contributions), the investment earnings can be withdrawn tax-free when used for qualified higher education expenses. When college funding is the objective, these tax benefits give 529 plans an edge over investing in the child’s name using UGMA or UTMA accounts that will incur taxes on investment earnings each year.

Despite the tax break, some parents are reluctant to use 529 plans because there is a potential downside. Earnings withdrawn from these accounts that are not used for qualifying expenses are subject to ordinary income tax plus a 10% penalty. To help college savers overcome this obstacle, Congress built a significant amount of flexibility into the 529 plan rules. Should a student who is the beneficiary of a 529 receive a substantial scholarship, withdrawals of up to the scholarship amount can be taken without incurring the tax penalty, though the earnings would be taxed as ordinary income. If a child decides not to go to college at all, the account owner (typically a parent or grandparent) has the option to change the beneficiary to another family member. Unused 529 plan funds can also be left to the student for later use for higher education for themselves or perhaps their future children.

Recent changes to the qualified expenditure rules have also added some flexibility to these plans. In addition to college and graduate school tuition and fees, books and supplies, room and board (including off-campus housing), computers, software and internet services, and accessibility equipment for students with special needs, up to $10,000 of 529 plan money can be used to pay for private K-12 education. A more recent change also now counts student loan payments as qualified 529 plan expenses.

The broad range of allowed expenses and flexibility regarding beneficiaries and ownership of 529s should leave college savers pretty comfortable that they will not risk having funds held hostage in 529 accounts because of the tax liability. For good measure though, the SECURE 2.0 Act, which just cleared Congress in December, allows for another interesting planning opportunity using 529 plan accounts. Starting in 2024, tax-free rollovers of 529 plan funds to Roth IRAs will be allowed. This provision will allow leftover funds in 529s to be used tax free for retirement, either for the original child beneficiary, or even the parent as account owner. For a child beneficiary, these tax-free 529 to Roth transfers offer a tremendous opportunity to jump-start retirement savings, allowing for decades of tax-free investment growth before the Roth funds need to be used for retirement. Using the beneficiary change provision, a parent precluded from contributing to a Roth IRA due to income limits could make themselves the 529 plan beneficiary and effect a 529 to Roth transfer to fund their own retirement.

​Because 529 plan accounts have high contribution limits relative to Roth IRAs, and very high limits on total contributions, you might wonder why one would not just fund 529s then convert them later to their own Roth IRA. Well, as you might expect, Congress put some limits in place to prevent this provision from being abused by high income taxpayers. First, the 529 plan must be funded for a minimum of 15 years before any dollars can be converted to Roth. This should encourage setting up 529 plan accounts early to start the clock, even if funding is low to start. Changing beneficiaries does not appear to re-start this clock. Second, 529 to Roth transfers are limited to the maximum annual IRA contribution amount as well as a lifetime maximum of $35,000. Finally, it appears that the individual making the transfer must have earned income to qualify, just like they would for making a traditional or Roth IRA contribution. Making a 529 to Roth transfer, however, would not preclude an investor from making a direct contribution to a Roth IRA as well.

One of the most notable updates included in the new law is an additional pushback in the age at which required withdrawals from retirement accounts must begin. Originally, Required Minimum Distributions (RMDs) were slated to begin once a retirement account owner reached age 70 ½, though the first withdrawal could be delayed until April 1 of the following year. The first SECURE Act pushed the RMD age out to 72 for those who turned 70 ½ in 2020 or later. SECURE 2.0 sets the RMD age threshold at 73 for individuals who turn 72 in 2023 and provides for an additional pushback in the RMD age to 75 for those who reach this milestone in 2033 or later. Note that individuals who turned 72 in 2022 are not impacted by the change and must take their first RMD by April 1, 2023, if they have not done so already. The age at which Qualified Charitable Distributions (QCDs) can be made from an IRA is not impacted by the RMD age updates. These charitable withdrawals can still be made by account owners who have reached age 70 ½ with the benefit being that QCDs are excluded from taxable income making this a tax-wise charitable donation strategy for taxpayers who are not able to itemize deductions on their tax returns.

While the pushback in the RMD age is unlikely to have a meaningful impact on retirees who will be counting on retirement account withdrawals to meet living expenses, it does provide planning opportunities for those who can delay such withdrawals. In these cases, the later RMD start date may allow for a few more years of Roth conversions designed to hedge against future tax rate increases and reduce future required withdrawals.

The penalty for withdrawing less than the RMD amount has also been favorably altered under the new law. SECURE 2.0 reduces the penalty from 50% of the shortfall to 25% and allows for a further reduction in the penalty to 10% if the shortfall is corrected before the earliest of the date a Notice of Deficiency is mailed to the account owner, the date the additional tax is assessed by the IRS, or the last day of the second tax year after the additional tax was imposed. It will still be possible to request full abatement of the penalty from the IRS, but this new provision offers an incentive for taxpayers to simply correct the issue as soon as it is recognized that an RMD fell short.

​In another RMD-related provision, SECURE 2.0 now allows for surviving spouses to consider a third way to handle inherited retirement accounts. Existing rules allowed spouse beneficiaries to treat the deceased spouse’s IRA as their own or to treat the account as an inherited IRA. The latter option allowed surviving spouses to delay the start of RMDs until the deceased spouse would have reached RMD age. For survivors who are older than their spouse, this approach allowed for RMDs to be deferred. Once the deceased spouse’s RMD age is reached, the survivor then has the option to transfer the inherited IRA into their own IRA. Starting in 2024, surviving spouses will have the additional choice to be treated as if they were the deceased spouse. This would also delay RMDs until the deceased spouse would have reached RMD age and the RMDs, once needed, would be computed using the Uniform Lifetime Table rather than the Single Life Table that applies to non-spouse beneficiaries. This will result in smaller RMDs. Further, if the surviving spouse dies before reaching RMD age, the beneficiaries will be treated as if they were the original account beneficiaries allowing “Eligible Designated Beneficiaries” to stretch withdrawals over their life expectancy rather than being stuck with SECURE 1.0’s ten-year withdrawal rule.

Adding to retirement savings is one of the best tax saving strategies because retirement contributions offer tax-deferred growth that is sure to enhance retirement prospects. This means looking at your year-to-date contributions to 401(k) or 403(b) plans and adjusting your contribution rate for the final pay periods of 2022. The ideal target is the IRS limit for these plans which is currently $20,500 with an additional $6,500 catch-up amount available for taxpayers aged 50 and older. How much can these additional contributions save in taxes for 2022? This depends on your marginal tax bracket, but the math is simple. If you are in the 24% tax bracket, each additional $1,000 contributed reduces your 2022 tax bill by $240. Taxpayers in the 37% bracket save $370 in tax for every $1,000 contributed to their retirement plan by year-end. For anyone with the cash to set aside for retirement, this is a rather good payback in the form of tax savings.

Self-employed taxpayers can still set up retirement plans for their businesses to reduce their 2022 taxes. SEP IRAs are one option for small business owners to set aside funds on a pre-tax basis for retirement. The contribution limit for SEP plans is 25% of net earnings up to a maximum of $61,000. This translates to a substantial tax savings, and, in this case, there is plenty of time to get the plan established and contribution made. SEP IRA plans can be established and funded any time before the tax filing deadline, including extensions. In most years, this means April 15, or Oct. 15 if a six-month extension request is filed. Note that a small business with employees maintains a SEP plan, the employees must receive a contribution to their SEP IRAs equal to the same percentage of compensation as that of the business owner.

Sole proprietors should also consider whether a solo 401(k) can be funded for 2022. These plans must be established before Dec. 31, but the contribution can be made any time before the tax filing deadline, including extensions. The benefit of these plans is that the business owner can make a “salary deferral” contribution that is the same as the 401(k) limit ($20,500 plus the catch-up amount if age 50 or older), as well as an employer contribution that is the same as what could be contributed to a SEP. This allows for more tax savings, but taxpayers who have a regular job with a 401(k) in addition to a side gig must account for the amount they have contributed to their workplace 401(k) in determining how much they can contribute to their solo 401(k) plan. The salary deferral limit applies per person so any amount deferred out of pay to the employer plan reduces the salary deferral amount that can be contributed to the solo 401(k).

​Taxpayers without self-employment income can reduce their taxes by contributing to a traditional IRA for 2022. The limit is $6,000 for those under age 50 with an additional $1,000 contribution allowed for older taxpayers. Taxpayers who also have 401(k) plans available to them must look at the income limits that determine tax deductibility of these contributions.

Those with savings outside of retirement accounts likely have some holdings in their portfolios that have unrealized losses given the downturn in both stocks and bonds in 2022. While it is never fun to sell losing investments, these losses can be harvested to offset any capital gains distributions that may come through from mutual funds or gains from sales realized earlier in the year. Excess losses can also be used to offset up to $3,000 or ordinary income. Placing trades to capture these losses can provide significant current tax savings but one must be careful not to trigger the wash sale rule by purchasing a substantially similar security to the one sold within 30 days before or after the sale that generated the loss. Doing so means the loss cannot be used on your current year tax return.