It's been a challenging year for plan updates with so much unknown in the world. Although your portfolio may not have seen its last bout of volatility, we’re at a point where we can focus our attention back on planning. This unusual year creates potential opportunities for some. Before we close out 2020, let’s consider how this year impacted your financial plan.
Did your income change in 2020?
Any time you incur a significant income change (more than a minor inflation adjustment) you should review your financial plan. Increased income provides an opportunity to save more, spend more. It might mean Uncle Sam is also looking for more. While a decrease in income creates challenges with spending, it may provide an opportunity to lower your tax burden.
If your income changed in 2020, review your retirement contributions and tax options. If your income was lower than expected, you might want to shift contributions from Traditional IRAs to Roth IRAs (or 401ks where available). If income was lower, you might consider converting a portion of your Traditional IRA to a Roth IRA. Both decisions are based on the relative difference between this year’s tax cost with future tax obligations.
Taxation is relative
You will likely continue paying taxes for the remainder of your life. A depressing reality, but this realization means you should compare your current tax cost against your projected future tax obligation. If you project being in a higher tax bracket in the future, you might be willing to incur a higher tax cost this year to avoid paying more in the future.
For example, consider a couple who lost one income this year. They made ends meet with one income, but saved a little less than normal. As we close out 2020, both incomes have been restored or are expected to be restored in 2021. In this case, the couple may find themselves in a lower tax bracket in 2020 than projected in 2021 (and beyond).
This couple may be willing to accept additional current tax cost today if they project it will save taxes in the future. For simplicity (the tax code is not simple), the couple can accept income at 12% in 2020. They project returning to the 22% bracket next year. They might consider accepting income that allows them to remain in the 12% bracket this year to avoid 22% (or higher) in the future.
Taxes under Biden
Many expected (and perhaps still do) increased with a Biden victory. So far, he’s promised no increase in taxes for those earning less than $400,000. Of course, the promise was made during a campaign, not while in office. We’ve heard promises before…”read my lips, no new taxes” before.
Biden’s current plan seems to be a partial reversal of the Trump Tax cuts (raising corporate taxes to 27 or 28%) rather than a full reversal. A full Trump Tax cut package reversal would likely move tax brackets higher across the board. The likelihood of a full reversal is lowered if the Senate holds a Republican majority. The Senate majority will be determined in early January when Georgia completes two runoff elections.
Taxes may increase after the Biden administration. The “Trump Tax Cuts” are scheduled to return to previous levels in 2025 if politicians take no action. While tax rate increases are an unknown, you can probably assume rates aren’t going lower.
Take gains, harvest losses?
Realizing tax losses in taxable accounts can help lower ordinary income in the current year. Realizing losses can offset realized gains in the current year and be carried forward to use against future gains. If following a passive approach, you can usually replace the current position with a similar position (but the same). This provides a tax benefit without impacting the overall allocation.
There is chatter of an increase in capital gains rates. Projected increases would target ‘high income’ earners. In this unusual year, especially if there is an expectation of returning to a higher bracket in future years, you might consider accepting gains (and the taxation) today. This would reset the cost basis for the future gains.
There is some discussion about taxing capital gains at death. If chatter moves closer to reality, you’ll need to review whether taking gains earlier makes sense. Without taxation at death, most prefer to hold positions with significant gains (often accumulated over a long period) for heirs.
When the positions are transferred to heirs, there is a ‘step-up’ in cost basis. If this is no longer the case, you may want to review the strategy.. Even if this doesn’t become law, you may consider gifting appreciated assets. If you are charitably inclined or want to move money to your children (or others) with a lower tax bracket, you might consider gifting ‘appreciated’ shares.
Not required but should you anyway?
The Cares Act removed the requirement of a Required Minimum Distribution. I think this is an interesting addition to the act. I am not sure why it was included. I assume the government wanted you to maintain savings for the future? Seems odd when most everything else in the act focused on getting money to people today to cover the cost of shutdown. I suppose avoiding paying tax on the withdrawals could be a reason, but taxes aren’t 100%. In addition, the government needs tax revenue to offset the additional spending.
But, I am not a politician and will therefore simply follow the rule. If the act says you don’t have to take your Required Minimum Distribution, does that mean you shouldn't? Maybe, maybe not.
Without consideration for future tax obligations, you would likely avoid taking a distribution this year. Why pay taxes this year if you don’t have to? But remember, you will likely have to take distributions on money remaining in the Traditional IRA (and incur taxation). Future distributions will be taxed at ordinary tax rates in the year taken. There are three considerations to review when accepting taxes now to avoid taxes later.
If the tax rate is the same and the market goes higher, a withdrawal today only taxes today’s withdrawal. If you decide to forego the withdrawal and the holdings appreciate, future taxation will be based on today’s withdrawal plus the gain.
For example, you withdraw $50,000 today at 22%. If the position appreciates to $60,000 in the future and you remain in the same tax bracket, you may find yourself paying taxes of 22% on $60,000. The taxation on the $10,000 gain can be avoided if converted to a Roth IRA or controlled (capital gains versus ordinary income) if moved to a taxable account. In this scenario, tax rates remain constant. If tax rates rise, the benefit of this strategy increases.
As you project future taxes, consider a scenario where you change filing status. Typical changes include getting married, becoming widowed or adding dependents. Each of these can change your bracket without a significant change of income. The loss of a spouse may raise the survivor’s tax burden. In this case, it might be advantageous to accept additional taxation today.
If the withdrawal is ultimately passed to the next generation, there are opportunities to extend tax benefits. If leaving assets, a Roth IRA allows tax-free growth with annual distributions (tax-free) for 10 years. For those with a high probability of leaving an inheritance, leaving assets as Roth versus Traditional might be an option.
Finally, once you’ve reached the age (72) you are required to take distributions, your RMDs must be taken before you consider a Roth conversion. Without a requirement for withdrawal this year, you can convert to a Roth without having the hurdle (and taxation) of fulfilling your required distributions first.
Life changes in 2020?
Increased ‘closeness’ might have created life changes. A couple might realize they actually can spend time together and take the next step of sharing a household or getting married (with limited guests at the wedding, of course). If you really enjoyed spending time together, perhaps there will be a new addition to the family in 2021.
Both scenarios create a new dependence on your (and their) income. A new mortgage can be managed with two incomes. Would the same mortgage be managed with only one (or a decrease in one)? A family addition adds a whole list of new expenses and liabilities.
In either case, testing your plan for the risk of losing income might be in order. Keep in mind, in most cases, marriage or a new child creates a window to change insurance options if you are covered by an employer plan. Managing insurance when you know you’ll have multiple opportunities to change coverage can be advantageous with some prep.
Unfortunately, the opposite might be true as well. Too much time together may lead to divorce or separation. If that is the case, reviewing your plan prior to finalizing divorce will also make sense. Assuming everything should be divided equally is not always the best answer.
Open Enrollment Season
November tends to be the month when employers open a window for change to employer provided options. If you have changes in your life, don’t simply assume last year’s options remain the best options going forward. You should also consider the tradeoff between employer provided options with options outside of your employer. For example, consider the benefit of holding life insurance with your current employer (cost) versus the risk of portability (ends when you no longer work for that employer).
If you are still in the workforce, my biggest concern when considering open enrollment is your disability coverage. Becoming disabled carries a greater cost than dying. If you (or your partner) become disabled, income is lost, but expenses remain. In death, the income stops, but so does some of the expense (I know...morbid but reality). Don’t overlook this benefit.
Have your goals changed in 2020?
If any of the events discussed above happened, you likely want to update your goals (and your expenses). An adjustment to goals is not solely for those with traditional life changes. Lots of planned goals for 2020 were cancelled. I have a few clients who retired in early 2020. Needless to say, they are disappointed with retirement so far. They had travel and spending goals that went unfulfilled.
The restrictions and consequences of 2020 might have you reconsidering your perspective of the future. We rarely considered a scenario where others told us we couldn’t eat at restaurants, travel the world, visit our families, or enjoy hobbies. The challenges of 2020 may bring greater awareness of what is important to you and perhaps what is not.
Did the restrictions and reality of 2020 alter your goals?
When discussing cancelled travel plans, should we simply move the 2020 trips to 2021 (assuming we can)? Maybe travel lost its appeal. Or at least the thought of traveling abroad is off the table (for now). For those looking to travel, the low cost of travel might make you eager to take advantage of opportunities.
If you decide to forego international travel, should we include additional domestic travel? If yes, will you be traveling via plane, train or automobile? Perhaps substitute train for RV? You might decide to get away from the summer heat for a month (or more) at a time. If so, what does that look like? For those not living in the desert, you may be looking to escape the winter cold for a month at a time. What does that look like?
You may have taken up a new hobby. Should we include a future expense? An interesting development may be the newly realized ability to work from home. I have clients working from cabins and out of the country (OK...Canada, but still). Does this change impact your goals and/or expenses?
Perhaps the greatest realization of 2020 is that life can change quickly. The restrictions may wake a desire to do more now (or when we can) rather than wait. Spending early often has people questioning whether they are sacrificing their future when spending today. Saving for ‘later’ might leave you with regrets. No matter the reason, we can test spending more today and discuss the tradeoffs.
It would be nice to believe the uncertainty of 2020 will end with the flip of a calendar page. I am not that naïve. We’ll continue with unknowns going forward. Our greatest uncertainty is the ongoing battle with COVID. Multiple states are beginning or extending versions of shutdown.
At the same time, headlines propose a 90% or higher success rate for trials from Pfizer and Moderna. If the projections are true, we can hopefully get back to some version of normalcy in 2021. Until a vaccine is widely available (at a reasonable cost), we will likely continue negotiation between the economy and safety.
It appears the uncertainty of the election has been minimized...at least for now. Depending on the results of the Georgia runoff, we could find ourselves with a divided government. This is likely a good outcome. Hopefully, this means political parties begin to work together towards a common good (we’ll see).
By the way, here is an interesting point. Assuming Georgia elects at least one Republican, this will be the first time since 1884 (Cleveland Administration) in which a newly elected Democrat President didn’t enjoy a Democratically controlled House and Senate.
I’ve been battling a cold (thanks to Steph for sharing) for a few days. Prior to Covid, I would have gone into the office and powered through. Today, I stay at home because you just never know and most importantly, there are others in the building with compromised conditions. So, I proceed with a little extra caution.
Proceeding with a little extra caution might be the theme of 2021.
As we consider portfolios, caution means remaining a little more conservative. It means having a plan to add stock if markets fall. The S&P 500 currently trades ABOVE the highs reached before the official introduction of the coronavirus.
Markets rally on any mention of a vaccine or new round of stimulus. Either would be good for markets in the short-term. Whether they provide a long-term benefit is an unknown.
I’ve read multiple articles from doctors questioning the high numbers from Pfizer and Moderna. I hope the numbers are correct and our primary consideration will involve how to distribute.
Likewise, stimulus adds to debt. There is a new solution for debt. It is called Modern Monetary Theory (MMT). The theory says we can print money with limited cost until inflation gets too high. Perhaps we can continue to print money without consequence. I am not convinced. I recently listened to an interview with Stephanie Kelton. I ordered her book (The Deficit Myth). I’ll share my thoughts in an upcoming post.
If we entered 2021 today, we would be entering at a higher market valuation than where we entered 2020 (at least from the US large cap perspective). We would do so with higher unemployment, higher debt, with some states and countries returning to lockdowns. I think I’ll remain a little cautious when considering portfolios.
When it comes to your plan, I recommend being optimistic. Let’s consider what you learned about yourself and your goals during this unprecedented time. I am curious to hear how your plans for the future changed and how adjustments to your action steps can improve the probability of reaching newfound goals.
My new goals include playing more. Stephanie and I played in a volleyball tournament a couple of weeks back. We entered with one of her friends and her father. Both fathers coached their daughters in developmental volleyball. The daughters are quickly becoming the coach.
There is no doubt the girls would have done better without us, but it was fun (for all of us). The tourney made me realize I want to play more and coach less. This includes the two sports I follow...volleyball and hockey. So, if I am walking gingerly, have a black eye, or have an arm in a sling when we meet next, you can guess why.
I look forward to seeing 2020 in the rear view...