The Informed Investor
At long last, this year’s dramatic election is ending. Whether your candidate won or lost, you may be wondering how that might impact your wealth management in the next four years.
According to history, the stock market usually does not care whether a Republican or Democrat is in the White House. Data over the last 78 years shows very little difference in stock prices two years after an election, regardless of party.i So from a wealth management perspective, that is not as important as it may seem.
However, there are other things we can learn from this year’s election.
Lessons from the Election
As we all observed, this election was profoundly emotional for many people. To manage our money with discipline, however, that emotion needs to be put aside and kept out of our financial decisions.
Instead of letting emotions cloud our investing decisions, we need to make decisions with objectivity, based on knowledge.
This election year has been a reminder that we cannot control everything that happens in life. Instead of worrying about what we cannot control, we should focus on that which is within our control:
- Choosing our investments
- Diversifying properly
- Managing risk
- Sticking to our plan
What Changes Are Warranted Based on the Election?
Since we should be focusing on things that are within our control, are there any investment changes that make sense based on the outcome of the election?
First, President-Elect Biden has proposed increasing tax rates on those making more than $400,000 per year. In addition, he has proposed increasing the long-term capital gains tax rate for those with an income over $1,000,000.
Of course, if the divided congress continues, these changes may not materialize.
However, there are other factors at play. The pandemic has been a remarkably expensive experience for the country (as well as most countries across the world). With trillions of dollars spent on stimulus and relief programs, amid a backdrop of rising debt, there’s a high likelihood that tax rates have only one way to go in the future. That is most likely up.
With that in mind, revisiting your strategy based on potential tax increases makes sense.
Here are some ideas to consider this tax year and next. Of course, these are general recommendations; please consult your tax professional for specific advice regarding your personal situation.
- Look at shifting income forward
Tax rates are low now, and as previously mentioned, very likely will increase in the future. In light of that, if you have any income you can shift into the current year, it might be worth doing so to take advantage of what may be a lower tax rate in 2020.
- Contribute new money to Roth accounts
Building on that same concept, if you can prioritize contributions to Roth accounts, that may save you tax dollars in the future. Roth accounts are retirement accounts where you pay taxes upfront on contributions, then all of your future gains and withdrawals (after the age of 72) from the account are tax-free. By taking the tax hit now, you will not have to pay taxes on withdrawals during your retirement years. The withdrawal rules that apply to Roth IRAs are different from regular IRAs, SEP IRAs or Simple IRAs. The first five-year rule states that you must wait five years after your first contribution to a Roth IRA to withdraw your earnings tax free. The five-year period starts on the first day of the tax year for which you made a contribution to any Roth IRA. You cannot withdraw funds until your reach the age of 59 ½.. There are exceptions to the early withdrawal penalty, such as a first-time home purchase, college expenses, and birth or adoption expenses.
Unlike traditional IRAs, there are no requiremend minimum distributions (RMDs) for Roth IRAs during the account owner’s lifetime. One challenge with Roth IRAs is that your beneficiaries may not be aware of the RMD rules. So if you have a Roth IRA, do your beneficiaries a favor. Let them know the basics about distributions—or they’ll get a costly lesson later when they’re hit with a 50% penalty on the amounts they should have withdrawn. As long as everyone understands the rules, you and your heirs can enjoy years of tax-free growth and tax-free income from your Roth IRA.
- Consider rollovers into Roth accounts
Are you in too high of a tax bracket to have a Roth IRA? Then you may be able to use a “backdoor” Roth option, which is a strategy that can help you convert an existing IRA to a Roth account.
Or even if you are not in that higher tax bracket, there may be strategies to convert (or “rollover”) existing retirement accounts into Roth accounts. This needs to be done carefully with the close assistance of a professional so you do not make a mistake and incur penalties, but this can be a timely and prudent move.
When you roll over the account, will have to pay taxes now on any money you previously contributed pre-tax which will incur a bigger tax bill in the current year. However, this can be smart to do now with current tax rates and you will gain the benefit of no further taxation on the money you invest in a Roth account.
- Consider taking capital gains this year
Since capital gains taxes very well may be increasing, it might be time to go ahead and sell some of the highly profitable equity positions that you have been holding on to. While you will have to pay taxes on the gains, you very well may be paying them at low historical rates.
Also, you may be able to offset some of these gains by finding some tax loss harvesting opportunities. Please see our previous article on this topic.
Did You Have an Income Disruption This Year?
2020 was a year rife with pay cuts, layoffs, and business disruptions. If you experienced any of those circumstances, this may be an opportunity. For single filers with incomes less than $40,000, or joint filers with incomes less than $80,000, you may have an opportunity to get tax-free capital gains this year.ii If that describes your situation, you may want to work with your tax professional to maximize this benefit.
Of course, you should work closely with your financial advisor and tax professional on these strategies so everything is handled correctly. Ideally, your financial advisor should be talking to you quarterly to make sure you are always taking advantage of these opportunities when they arise.
With the election finally behind us, hopefully some of these strategies can help you make 2021 a brighter year.
[i] Sigalos, MacKenzie. “Stop Stressing about Which Party Is Better for the Stock Market: The Data Shows It Doesn’t Matter Much.” CNBC, 6 Nov. 2020, cnbc.com/2020/11/03/are-republicans-or-democrats-better-for-the-stock-market.html.
[ii] Szala, G. (2020, November 23). 4 Ways to Soften Fund Investors’ Tax Pain: Morningstar | ThinkAdvisor. Retrieved from thinkadvisor.com/2020/11/23/4-ways-to-soften-fund-investors-tax-pain-morningstar/
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