Windsor Brief for August 2022
Investing:Is the Glass Now Half Full?
Planning:529 Plan Qualified Education Expenses
This month’s Windsor Brief is a timely update to the various data points the market has received in the past few days. Investors look for clues in this data and what it might mean for investing the remainder of this year.
Our Financial Planning section offers a timely discussion on the Back-to-School season and utilizing a 529 Plan to pay for upcoming education expenses. We review what is considered a qualified education expense in order to maximize the income tax benefits of a 529 Plan.
If you’d like to talk to us further about these topics or about any of your financial planning or investment goals, please do not hesitate to get in touch.
Investing: Is the Glass Now Half Full?
As we enter August the market has begun to show some signs of life. Although it has been a tough seven month start to the year, investors are constantly looking forward 6-12 months to what is on the horizon. And if the past couple weeks are any indicator, we may eventually find smoother sailing ahead, though undoubtedly there will continue to be chop along the way.
The market has been laser focused on two very specific topics, inflation, and earnings. Inflation encompasses the actual inflation numbers, interest rate levels and more importantly commentary and action from the Fed. On the other hand, earnings are a front row view into how corporations are viewing the economy and the impact the economy is having, and will have, on their businesses. Combined, inflation and earnings are driving the markets. Interestingly, although inflation readings and earnings / GDP results have been negative on the surface, investors are now beginning to take a glass half full approach.
Why is that? Let’s start with inflation and the Fed. Despite the worse than expected inflation report, the Fed came out with very measured commentary and reassured the markets. And when it came to act this past week, the Fed raised rates the expected 0.75% and, importantly, once again gave reassuring forward looking commentary to investors. The question becomes what does the Fed see to give them confidence in the inflationary outlook especially since the CPI reading has been above expectations the past two months and over 9% the last reading. The Fed is not just looking at the CPI number, rather they incorporate many “leading” indicators and measures into their analysis of inflation. A few examples are shown below of the myriad of data the Fed incorporates into their forward analysis:
Inflation - There is more to it than just CPI
In addition, when you look at the most recent pricing data in categories such as travel, autos, wheat, oil, fertilizer, lumber, etc., you begin to see inflation may have peaked and is beginning to slow.
Airline and Hotel Pricing Appears to Have Peaked
Source: Hopper.com, BLS, Fundstrat
Surprisingly, we are even seeing steep drops in agricultural commodities and fertilizer, as shown below.
Source: Fundstrat, Bloomberg
Similar patterns are showing up across many different categories. This may indicate that interest rate increases are beginning to have the desired impact on the economy and beginning to temper inflation. Investors are slowly beginning to look at inflation with a glass half full attitude as this may mean the Fed can maintain a more measured and consistent interest rate trajectory for the remainder of the year with no surprises.
Which leads us to earnings. Although the second quarter GDP result was negative for the second quarter in a row, which may be indicative of a recession, investors are more focused on actual corporate earnings as an indicator of economic health. As of last week, over 40% of the S&P 500 companies have reported their earnings for the second quarter. Investors have been bracing for negative earnings guidance this quarter, and indeed there have been some tough results from companies such as Wal-Mart, Meta (Facebook) and Snap (Snap Chat), to name a few. However, of the 40% that have reported earnings, roughly 75.8% have beat Q2 earnings expectations. Although this beat percentage is the lowest since the first quarter of 2020, it is well above the long-term average of 66%.
Percent of S&P 500 Companies Beating Earnings Estimates by Quarter
Thus, corporations are still doing OK despite the slowing economy. However, aside from reporting last quarter’s earnings, companies also provide forward earnings guidance. The slowing economy is providing cover for companies to give conservative forward guidance while still delivering better than expected Q2 earnings. More importantly, economists are using this corporate guidance and reducing their S&P 500 earnings estimates for 2022/2023 roughly in line with expectations. The lower earnings estimates are being viewed by investors as the glass is half full as the lower earnings reduces the risk of earnings misses in the future yet the reductions are not exceeding expectations or indicating the economy is cooling too quickly. It is expected this number will continue to fall and settle out in the $235 region over time.
2023 S&P 500 EPS Progression
In conclusion, 2022 has been a difficult year so far with inflation levels not seen in over 40 years. As the Fed has worked to aggressively raise interest rates to slow the economy and hence overall demand, pricing looks to potentially be peaking and rolling over across many segments of the economy. Investors are taking this this to mean there will be continued interest rate increases but in a more consistent and measured way. At the same time, there is clear evidence the economy is slowing and potentially in recession territory with two consecutive negative GDP reports. However, the corresponding earnings reports out of corporations has been roughly in line with expectations to slightly better. But the slowing economic outlook is giving cover to companies to provide conservative forward-looking earnings guidance, which is allowing analysts to reduce 2022/2023 S&P 500 expected earnings. The reduction is in line with expectations which has two benefits - it is a relief to investors it was
not worse than expected, and this lowers the earnings risk going forward. This has resulted in investors taking a glass half full view of the markets and the economy for the time being. Nothing is ever a straight line, and the market will continue to digest the ever-ending flow of economic data points. But for now, the glass looks to be half full….and hopefully will continue to fill.
Planning: 529 Plan Qualified Education Expenses
The beginning of August signifies the Back-to-School season. If back to school means going off to college, then you may be looking at your college invoice and getting ready to pay the bill. The average public in-state college cost is $27,000 per year and the average private college cost is almost $56,000 per year (includes tuition, room & board, etc.). Today we are going to look at utilizing your 529 Plan to pay the college bill.
As a reminder, a 529 Plan account is funded with after tax contributions. Some states do offer state income tax deductions or credits for contributions. For example, Indiana (our home state) offers a 20% Indiana state tax credit on contributions to the Indiana College Choice 529 Plan up to a maximum credit amount of $1,000 per year per tax return. In 2023, the maximum credit will increase to $1,500.
529 Plan accounts grow tax deferred. The earnings will not be taxable if the withdrawal is used for qualified education expenses. Qualified education expenses include the following categories:
1. Eligible College or University program expenses including:
- Tuition and mandatory fees
- Required books & supplies
- Room & board (if enrolled at least half time) for on campus and off campus housing
- Special needs equipment
- Computer (if used exclusively for college)
- Computer related expenses
2. Apprenticeship program: fees, books, supplies and equipment required to participate in a registered apprenticeship program.
3. Primary or secondary school: up to $10,000 per year for tuition only for K-12 school. For an Indiana 529 plan, the K-12 school must be located in Indiana.
4. Student Loan Repayment: Federal law also includes as a qualified expense up to $10,000 in student loan repayment per borrower (lifetime limit). Please note that some states, including Indiana, do not conform to this federal law – which means a student loan distribution would be subject to recapture of your Indiana state tax credit.
Important note: the qualified withdrawal from the 529 Plan must occur in the same calendar year in which the qualified expense is paid.
If the withdrawal is not used for a qualified expense, then the earnings portion of the amount withdrawn will be taxable as ordinary income plus subject to an additional 10% penalty tax. In addition, if you received a state income tax credit, then the credit would be recaptured (i.e., you would need to pay it back). Examples of typical college expenses that do not qualify include college application & testing fees, travel expenses, health insurance, fraternity or sorority dues, club, or sports fees.
If your student receives a scholarship, you can take a non-qualified withdrawal up to the scholarship amount which would still be taxable, but not subject to the additional penalty tax or credit recapture.
A 529 Plan is a great vehicle to save for education expenses. Windsor would be happy to run college education models to help you determine the recommended saving level based on age and college funding goals. Windsor can also help you navigate the 529 Plan process to help you take advantage of the tax benefits.