Author: Emily Frazier, Business Development Page 1 of 3

The Fed: Its History & Connection to the Markets Pt 1

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Over the last several market days, there was an increase in volatility and selloff in the equity markets. June 11th the Dow had its biggest one-day loss since March. This came one day after Fed Chairman Jerome Powell and the rest of the board concluded their two-day meeting and held a post-meeting press conference. In his press conference Powell announced that interest rates were left unchanged and near zero, unemployment was at an all-time high, and he projected a very slow economic recovery from this “pandemic-induced” recession. So, what is the Fed’s connection to the markets and economy, and what type of impact can they have? It is always best to start with why the Federal Reserve System was created and for what purpose. This blog will briefly cover the history of America’s central banking system, its structure and its overall purposes.

After the revolutionary war, Alexander Hamilton led several attempts at forming a central bank for the United States, but each attempt failed. Up until 1913, the United States was plagued with frequent financial pandemics, liquidity issues and high rates of bank failures. As a new country with these issues, the U.S. economy became a risky place for capital to be invested both for international and domestic investors. This lack of trust in the banking system was stunting America’s growth in its agriculture and industry. It was finally at the demand of J.P. Morgan, after the panic of 1907, that he pressured the government into acting on a central bank plan. J.P. Morgan, a wealthy financier, had bailed out the federal government several times up to that point. One instance was in 1895 by providing $65 million in gold, and another in 1907 when he convinced other bankers to provided capital and restore liquidity to desperate markets. That was after Morgan had already bailed out several trust companies, a leading brokerage house, New York City and the New York Stock Exchange.

Thus, on December 23, 1913 Congress passed, and President Woodrow Wilson signed, the Federal Reserve Act of 1913. The Federal Reserve website (www.federalreserve.gov) states this, “The Federal Reserve Act of 1913 established the Federal Reserve System as the central bank of the United States to provide the nation with a safer, more flexible, and more stable monetary and financial system.” The Federal Reserve, or commonly referred to as the Fed, has the purpose of managing the nation’s monetary policy by manipulating the money supply and interest rates. This was to smooth out the booms and busts of normal economic cycles. Determined to not have one central bank, the Federal Reserve Act purposely established three entities:

  1. A central governing board
  2. A decentralized operating structure of 12 reserve banks
  3. A combination of public and private characteristics (Federal Open Market Committee)

The Federal Reserve board initially consisted of seven members: the Secretary of Treasury and Comptroller of the Currency, and then five others appointed by the US President and confirmed by the Senate. Of those five appointed members, the President would designate one as “governor” and one as “vice governor”. The active executor of the Fed would be the governor. The board leadership structure has gone through several changes to morph into what we are familiar with today which is a Chair, a Vice Chair, and Vice Chair for Supervision and then 4 other board seats, making a total of 7 possible positions. Each are nominated by the President of the United States and confirmed by the Senate. Each member serves a 14-year term, with one term beginning every two years on the 1st of February on even numbered years. The following are the current Board of Governors of the Federal Reserve System:

  • Chair: Jerome H. Powell
  • Vice Chair: Richard H. Clarida
  • Vice Chair for Supervision: Randal Quarles
  • Michelle W. Bowman
  • Lael Brainard
  • Vacant Position
  • Vacant Position

The Act established 12 Federal Reserve banks instead of relying on one “central bank” and they were based on a geographic division of the United States. In 1913, these boundaries were based on the biggest trade regions and their related economic needs. The 12 bank districts are: Boston, New York, Philadelphia, Cleveland, Richmond, St. Louis, Atlanta, Chicago, Minneapolis, Kansas City, Dallas, and San Francisco. These banks operate independently but under the greater supervision of the Federal Reserve Board of Governors. Each bank has a nine-member board of directors and is responsible for gathering data on the economies and businesses of its local communities. This information is used to influence decisions made by the Board of Governors and the other entities of the system.

The Fed is in its 10th edition of The Federal Reserve System Purposes & Functions which details the structure, responsibilities and aims of the U.S. central banking system. The Fed performs five functions to promote the operation of the U.S. economy:

  1. Conducts the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy
  2. Promotes the stability of the financial system and seeks to minimize and contain systemic risks through active monitoring and engagement in the U.S. and abroad
  3. Promotes the safety and soundness of individual financial institutions and monitors their impact on the financial system as a whole
  4. Fosters payment and settlement system safety and efficiency through services to the banking industry and the U.S. government that facilitates U.S.-dollar transactions and payments
  5. Promotes consumer protection and community development through consumer-focused supervision and examination, research and analysis of emerging consumer issues and trends, community economic development activities, and the administration of consumer laws and regulations.

Understanding why the Federal Reserve System was created and for what purpose, establishes a framework to further understand how the Fed and their monetary policy affects the behavior of the markets. No matter the investment style or philosophy (active vs. passive management, technical analysis vs. fundamental analysis) what the Fed decides to do in regards to money supply and interest rates does in fact influence buy and sell decisions for both retail and institutional investors. However, instead of skimming the minutes of Fed meetings or staying glued to a post-meeting press conference or senate hearing, we prioritize the analysis of price movement rather than the underlying fundamentals of a security or economic numbers. It is our belief that what is happening both in the economy and with a particular company (if stock) or a company’s debt (if bond) is all reflected and priced into the security, index, market, etc. By placing our priority on analyzing price trends, we are able to be active traders on what is currently happening. This allows us to manage risk for our clients and shareholders.

What is a 401(k) and Should I have One?

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A 401(k) plan is a tax-advantaged retirement savings account that can only be accessed through a company that offers them to their employees. A 401(k) is a tax qualified, defined contribution plan defined in subsection 401(k) of the Internal Revenue Code (hence the name). You should definitely take advantage of a 401(k) if your company offers one with matching benefits.

Let’s get some definitions and facts straight:

As mentioned above, a 401(k) is ‘tax qualified’ or ‘tax-advantaged’. What does ‘tax-qualified’ mean? It means that there is some tax benefit involved.

It is also a ‘defined contribution plan’ meaning the ultimate account value depends on the total amount contributed, along with interest and capital gains from the plan’s investments.

The contributions to your 401(k) plan come from your paycheck and can come from your company if they have a contribution/ matching program. 403(b) and 457(b) are like a 401(K). You may have a 403(b) if you work for a non-profit or a 457(b) if you are a government employee.

Tax-Qualified: So what’s the tax benefit?

Your contributions to the plan are paid with pre-tax dollars, meaning they are taken ‘off the top’ of your gross salary, reducing your taxable earned income. Those pre-tax dollars get to grow tax deferred. Because of that deferral, taxes become due on the 401(k) funds once the distributions begin.

Bottom line: not only are you able to reduce your taxable income for the year, but your pre-tax dollars grow and experience compound interest tax-deferred!

When it comes time to take distributions from your 401(k) you pay taxes at that time. Speaking of distributions, you can withdrawal from your 401(k) without penalties when you turn 59 ½ . The April following the year you turn 70 ½  you are required to take a minimum distribution based on a formula.

What happens if I want to take money out before I am 59 ½ ? You can but there are several things to consider.

  1. First you will be subject to a 10% tax penalty.
  2. You will have to pay your normal income tax on the withdrawal on top of the 10% penalty.
  3. You may not be fully ‘vested’ with your plan. Vesting is a term used to refer to degree of ownership that a employee has in a 401(k). Think of it as what you are entitled to. The vested schedules are determined by the company. For example, you may have to work with the company for 5 years before you are 100% vested. Often times employers use vesting schedules to encourage employee retention.

All of these factors can significantly reduce your hard earned savings, so it is best to not withdrawal from your 401(k) prior to being 59 ½.

There are exceptions to the 10% penalty that include situations like disability or medical expenses greater than 7.5% of your adjusted gross income. For a full list of the current exceptions this is a helpful link: irs.gov Keep in mind, the point of a 401(k) is retirement savings.

Roth 401(k) vs. Regular 401(k)

A Roth 401(k) is fairly new and was introduced in 2006. A Roth 401(k) is being offered more and more, with over half of all companies offering this type of 401(k). Whenever you see Roth think after tax dollars. 401(k) contributions are made with PRE-tax dollars. Roth 401(k) contributions are made with POST tax dollars. That means you pay the taxes on your contribution now, instead of when you withdrawal those funds.

The Roth 401(k) benefit is that you may be in a lower tax bracket throughout your contribution time than at the time of distribution when you pay the tax on a traditional 401(k).

You will still have to pay taxes on the ‘employer match’ part of your Roth 401(k) but you will not pay on the earnings/growth or contributions. Something to consider in regards to utilizing either a Roth 401(k) vs. the traditional 401(k) is the unknown of future tax brackets and tax percentages.

Rolling out your 401(k)

There are several instances that will call for a ‘roll-out’ of your 401(k). ‘Roll out’ or ‘rolling over’ just means to transfer and in this instance, you are ‘rolling out’ your 401(k) plan into a different type of account structure. In this blog we will cover rollouts due to changing companies or retiring.

If you change employers and had a 401(k) with your previous employer, you can rollout that 401(k) into an Individual Retirement Account (IRA) Rollover with no tax penalties or change to tax structure. One of the best explanations of this process is to visualize a jar of money and a tiny sweater. The jar represents the money you have saved, and the sweater represents the tax structure or ‘account type’. Think of the sweater as tax protection! Once you are no longer an employee you can take your 401(k) distribution and transfer it directly into an IRA rollover to make sure you are not penalized or taxed. You basically take the jar, remove the 401(k) sweater, and put on the IRA rollover sweater quickly!

The IRS gives you 60 days or else it considers it a distribution and if you are under 59 ½ all the penalties and taxes will be due.

Once your 401(k) becomes an IRA rollover you have full control in how you manage those assets. The same process is involved when you retire. If you have any questions in regards to how to invest your IRA rollover, or to assist you in an IRA rollover you are more than welcome to give our office a call!

Final Thoughts

A 401(k) is a tax-qualified retirement savings plan offered through an employer and it should be part of your overall financial plan if your company offers one and matches employee contributions. Here are some final thoughts to keep in mind:

  • This is only a piece of your overall savings and financial plan, it shouldn’t be your only one!
  • Everything from your budget to your investment plan is highly personalized to your needs. What works for one person may not work for you yet.
  • Keep your 401(k) for retirement- do not withdrawal early!
  • If your company matches then you should definitely have a 401(k) plan. Contribute as much as you can up to your company match. Then utilize other retirement savings outside of the 401(k) if you would like to save more.
  • And finally, Spectrum is always here to help you answer any questions when it comes to your investments.

Spectrum does not hold itself out as experts in 401(k) and/or retirement matters.  This article is meant as an educational piece, so investors understand general concepts.  For specific details relating to your situation, please contact a CPA, attorney, or 401(k) specialist.

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Spectrum Financial, Inc 2020