Talk is running rampant in Washington and Wall Street over President Donald Trump’s potentially big tax cuts. Now, this isn’t a done deal, but suppose President Trump’s income tax plani is adopted. (It probably won’t be, in its entirety, but let’s pretend, since it is an area where presidential and Congressional interests overlap.) While many think of the impact to the broad economy, your financial plan could also be optimized if Trump’s tax cuts pass.
The Trump tax plan amounts to income tax cuts across the board, and fewer tax brackets. A boost to the standard deduction would also see more folks not paying any income tax at all. In short, almost everyone should see greater after-tax incomes if and when such proposals are signed into law. Higher take-home pay in the possibly near future lowers the attractiveness of tax-deferred and tax-exempt investment vehicles because the value of any traditional plan’s pretax deduction would decline.
It might not happen. Cutting taxes will require legislation, and while the Republicans have a big House edge, their lead in the Senate is a tight 52 – 48. Democrats can filibuster legislation, if they so choose. Moreover, Republicans are not a cohesive bloc, and it remains to be seen how deficit hawks in the party feel about slashing taxes (particularly since Trump has simultaneously pitched increased government spending). But in the event Trump tax cuts become a reality, here are three key financial planning points to consider.
If your federal income taxes are lowered, consider directing more of your savings into after-tax Roth IRA and 401(k) plans than pretax plans. Chances are you’re contributing more to traditional IRAs and 401(k) plans because you expect to be in a lower tax bracket in retirement and benefit from shielding more of your pretax income now. That’s good financial planning. But lower income taxes could change that calculus. Talk to your tax professional about the impact on your situation; you may want to shift emphasis to a Roth plan. It might also be beneficial to consider Roth conversions—again, talk to a tax professional, but it is a worthwhile conversation to have.
The yuuuuuuge benefit of a Roth savings plan is that all withdrawals—including the gains—are tax free (so long as you are over age 59½). Instead of paying income taxes on what could be a fairly substantial nest egg after long-term appreciation in a traditional IRA or 401(k), you wouldn’t have to fork over anything after the initial income tax on the original—and probably much smaller—sum once it’s deposited in a Roth. The more the market appreciates—and history strongly suggests that’s what stocks do over long periods despite market volatility—the more you’ll enjoy tax-free compounding.
In the same way that tax-deferred savings plans are less advantageous as income taxes drop, so are tax-exempt investment vehicles, where municipal bonds figure most prominently. Municipal bonds’ key attraction is usually their tax status. If you buy the bonds of the state you live in, the interest will very often be exempt from federal, state and local tax. This can be attractive for high earners, boosting what we investment eggheads call, “taxable equivalent yield.” Taxable equivalent yield is a financial planning calculation to compare munis’ after-tax yield with other non-tax-favored bond types. Here is the formula:
Taxable Equivalent Yield = Municipal Bond Yield / (1-Tax Rate)
Let’s say you and your spouse have combined income of $250,000. You’re presently in the 33% tax bracket. Now, let’s imagine you are considering a 3.5% municipal bond. Factoring only the 33% federal rate means a taxable bond must yield 5.2% to match the muni after taxes—1.7 percentage points more! If Trump’s tax cut passes, the 33% bracket is gone. Based on your income, you’d be in Trump’s 20% bracket. The same 3.5% muni would have a taxable equivalent yield of 4.4%. It isn’t hard to imagine finding a corporate bond that would top the gap. Your financial plan may have to adapt to this.
Perhaps the greatest advantage of having more take-home pay is that you have more to invest for longer. As Albert Einstein once remarked, “the most powerful force in the universe is compound interest.” The hypothetical portfolio in Exhibit 1 shows what saving just $4000 a year can net you after 30 years. Using 8% returns, which is conservative,ii consistently saving around $16 a working day and investing it, would earn you about $489,383 in three decades. Halving those returns still makes you $233,313 richer. Obviously, circumstances change and this is for illustrative purposes only, but it does show the best financial planning move you can make when you come into more money—whether through a tax cut or otherwise—is to save and invest it if at all possible; the more and longer the better.
Source: Fisher Investments Research.
While it’s way too early to start counting on a larger paycheck courtesy of the IRS, financial planning is about looking ahead and being prepared. Considering how your financial plan might change in light of potential new tax changes—and basic investing principles—is a worthwhile exercise and prepares you to take the future head on.
iFor more information see our post The 2016 Candidates, Taxes and Your Portfolio
iiHistorical returns are closer to 10%; S&P 500 Total Return 12/31/1925 – 12/31/2016 = 9.92%. Source: Global Financial Data, Inc., as of 1/5/2017.