Financial planning considerations when inflation is high and interest rates are rising

September 21, 2022 | Market news

Key takeaways

  • Persistent inflation and rising interest rates can affect your ability to meet your financial goals.
  • Take time to review your financial plan to determine if adjustments are needed.
  • Consider taking specific actions if you’re looking to generate income to meet cash flow needs or growth in your portfolio.

Higher inflation (7% annual rate in 2021, more than 8% at various points in 20221) combined with rising interest rates contribute to a capital market landscape today that many investors find challenging. In response, you may be wondering if you should adjust your financial plan to help you continue pursuing the goals that matter most to you.

Your financial objectives and the level of risk tolerance you’re willing to assume will determine what moves you may want to consider. This doesn’t necessarily mean that your financial plan requires dramatic changes, but evolving market dynamics may present opportunities to better position aspects of your portfolio.

“If prices are rising at a rate of 7% while wage growth is at 3%, then clearly purchasing power is eroded for most people. This affects people at all wealth levels, and you should consider how your financial plan is positioned in light of that,” says John Campbell, senior vice president and east region managing director, wealth planning at U.S. Bank. “For example, with inflation at a high level and the potential to remain elevated, now may not be the best time to have a lot of assets tied up in cash earning virtually no return.”

Considerations for conservative investors with lower risk tolerance

If you’re trying to generate income to meet current cash flow needs, you may find yourself facing significant challenges in a high inflation/rising interest rate environment. Here are two tactics to consider.

Gradually shifting money out of cash

If you have significant cash holdings, it may be beneficial to move those dollars incrementally into bonds and other types of securities that offer more attractive yields. Other investments you choose won’t have the liquidity or relative safety of cash, but most likely will pay a higher rate of interest, moderating some lost purchasing power owed to inflation.

Charitable remainder trusts to generate income

If you own appreciated assets with a low cost basis, consider establishing a Charitable Remainder Unit Trust (CRUT) or Charitable Remainder Annuity Trust (CRAT). The asset is gifted to an irrevocable trust, which cannot be modified once established. As the donor, you receive an income stream (it must be at least 5% of the value of the trust) for your life, the life of you and a joint beneficiary (usually a spouse), or for a set period of years.

While dramatic changes are likely unnecessary, there may be opportunities to better position your financial plan to capitalize on evolving market dynamics.

An immediate tax deduction can be claimed based on the present value of the charitable interest that will be directed to the qualified charitable organization in the future. The charity will receive any assets that remain after the death of the income beneficiary or at the end of the term of years income is paid out to the income beneficiary.

“The value of the deduction is based on the present value of the future gift to a charity. If interest rates are rising, the gift will be valued at a higher level, providing a higher tax deduction to the donor,” says Campbell. He points out that a minimum cash flow of 5% each year, from a charitable remainder trust to its income beneficiary, looks attractive in the current environment.

And there may be favorable tax treatment on a portion of the income stream, which could be taxed as long-term capital gains or qualified dividend income – in addition to any tax-free return of principal. “This can be an attractive strategy for a person with charitable intentions who wants to find tax-efficient ways to manage a highly appreciated asset,” says Campbell.

U.S. Bank and U.S. Bancorp Investments and their representatives do not provide tax or legal advice. Your tax and financial situations are unique. You should consult your tax and/or legal advisor for advice and information concerning your specific situation prior to establishing any trust.

Considerations for aggressive investors with higher risk tolerance

If you’re seeking to generate growth in a portfolio, you should be aware that a higher inflation, rising interest rate environment can impact the performance of your financial plan. Here are some tactical considerations to keep in mind:

Maximizing 401(k) savings strategies

If you typically “max out” your contributions to workplace savings plans, you may be able to invest additional sums through employer matches and after-tax contributions for a current maximum of $61,000 ($67,500 for those 50 and older).

Roth IRA conversions

You may also want to consider converting funds in a 401(k) or traditional IRA to a Roth IRA – and paying taxes today – to generate tax-free growth of earnings for your retirement in the future when inflation and/or taxes might be higher. Note that if money remains in the 401(k) plan, it will be subject to required minimum distribution rules (currently effective at age 72).

Additional steps to consider

Beyond the considerations mentioned above, there are other steps you may want to explore to adjust your financial strategy to adapt to an environment with higher inflation and rising interest rates:

  • Pay down credit card debt. Look for ways to eliminate debts with high interest rates (which may adjust upward) to avoid facing higher expenses associated with this type of borrowing.
  • Seek more affordable borrowing options. If you aren’t able to pay off all of your debt, put a particular focus on loans that carry the highest interest rates and look to consolidate debts using a less expensive form of borrowing.
  • Invest in your own growth. Pursuing education or experiences that can enhance your ability to boost earnings can be a valuable way to protect your financial position.
  • Harvest your eligible investment losses. Tax-loss harvesting is a strategy that may be used when selling taxable* investment assets such as stocks, bonds and mutual funds at a loss to help lower an investor’s tax liability. You can apply such losses against capital gains elsewhere in your portfolio, which reduces the capital gains tax you owe. *Note: Tax-loss harvesting does not apply to tax-advantaged accounts such as traditional, Roth, and SEP IRAs, 401(k)s and 529 plans.

Take action that’s appropriate for you

The current economic and market changes may not require dramatic alterations to your own asset mix or financial strategy. However, some adjustments may be worth considering. You’ll want to meet with your financial professional and tax advisor to discuss strategies that are most appropriate for you.

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