How Will Federal Reserve Rate Changes Impact Tax Planning?
Leverage the Tax Code to navigate interest rate changes.
The Federal Reserve, after months of telegraphing its move, raised its key interest rate targets by a quarter of one percent last month (just 0.25%.)
It is momentous not for its size, but for its signal. The Fed has raised rates for the first time since 2006, which means it sees the economy headed in a positive, if not grand, direction as we end 2015.
One quarter point rise in rates, however, does not by itself impact businesses: A business loan of $100,000, for example, now costs an additional $250 to borrow for one year. However, business planning has to factor in a series of rate rises over the next few years, assuming the economy maintains a slow but steady growth. With each quarter point rate rise, another $250 gets added to the cost of that loan.
Tax planning is driven in part by the anticipated cost of money. When I find a tax benefit for a client, for example, I use interest rate estimates to calculate the net present value of the taxes that are deferred or saved. Doing so gives a clearer view about whether or not implementing a given tax planning move will be beneficial to the company and, ultimately, to its shareholders. Decisions to pay taxes now or later are partially driven by where we think interest rates will be over the next decade. If the Fed is serious about raising rates, we will have to adjust our forecasting assumptions.
Rising interest rates, of course, make money saved today more valuable in the future. To illustrate, if invested wisely at a 5% annual growth rate, the money saved on taxes today will grow and become more valuable with each passing year.
The interest rate rises will likely be slow, however, as the Fed is once again telegraphing its expected changes: “The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate,” the Fed’s statement said.
Given that, the impact of December’s rate increase is expected to have little material impact on the tax planning work I will be doing in 2016. More critical factors like tax bracket changes, revisions or renewals to depreciation rules, and the hard work of properly characterizing expenses and revenues all have a far greater impact on tax planning than do changes in the interest rates.
Questions people ask
Do small Fed rate moves change tax strategies right away?
A single small increase, like the recent quarter-point hike, usually does not change tax strategies immediately. Most tax planning is driven by bigger factors such as tax law changes, bracket shifts, or new rules for depreciation rather than modest or infrequent interest rate moves.
What matters more to tax planning than interest rate changes?
Factors like changes to tax brackets, updates to depreciation rules, and precisely categorizing expenses and revenues influence tax outcomes far more than changes in the Federal Reserve's interest rates. These aspects usually drive significant shifts in tax strategies.
How quickly will a series of rate hikes affect planning?
If the Federal Reserve continues raising rates as stated, the impact will be gradual. The central bank has signaled only slow, measured increases, so each individual hike may add modest costs, but the cumulative effect will take time to influence major tax planning decisions.