Election 2020: This One is Different
August 2020 | William Velekei, CPA, CFP®
Amid what has already been an unusual, unprecedented year we have a presidential election approaching quickly – very fitting for 2020, a year that will have a unique place in all of our memories for a long time to follow.
At the time of writing this, it appears that former Vice President Joe Biden will be the presumptive Democratic Party candidate to face the incumbent, President Donald Trump. As all elections are unique in nature, especially a presidential election, this one feels different. But, they are all different, right? Of course; however, 2020’s election feels a bit like an oxymoron, figuratively speaking: the most important event in 2020, until it wasn’t anymore.
Coming into this year, Election Day was set to dominate the headlines until November. Enter COVID-19, the one event that could overtake the political pundits and news outlets, and put this election on the back burner. Pre pandemic, there was a heightened sense anticipating this election until the world’s attention completely turned to the global pandemic and the disruption that followed. Fast forward to now, it seems as if the virus has only exploited the issues that were slated for debate in any “normal” election year of our time: healthcare, social equality, taxes, and the wealth gap.
Political debates these days are tireless. We will not make any predictions of outcomes; it is not our job, we will leave that to the experts. However, it is our job to evaluate the ramifications of the possible results and how they could affect your family’s financial position. We wanted to share with you a few pertinent themes we are thinking about as we inch closer to November in relation to capital markets and your personal financial well-being.
Republican vs. Democrat: Does it even matter?
While there is no doubt the President of the United States is the most powerful position attainable in the world, the office does not come with absolute power. We have to remind ourselves this is how the Founding Fathers intended our government to function, with balance. Every Presidential agenda has to take into consideration the Senate and the House of Representatives, the two bodies that make up Congress. While the presidential election will get the front-page headline, from a market perspective, Congressional elections are just as important.
History tells us the markets prefer a divided government, or gridlock, in comparison to one political party holding the power of the White House and both houses of Congress. As seen in the graph below, the two best annualized return periods come from a split party, President and Congress, compared to a unified government. It may be counterintuitive if you think of Washington as a business; no business grows and is successful if management is paralyzed by stalemate. However, Wall Street enjoys the comfort in knowing that compromise from a divided government keeps policy as close to the status quo as normal. If there is one thing we know investors dislike, it is uncertainty.
With the state of politics in 2020 seeming more polarized than ever, emotions are running high. It is important not to let those emotions tied to political opinions and ideas interfere with your long-term investment objective and plan. Making irrational investment decisions based on possible political outcomes has proven not to work in investors favor. While we agree tactical financial planning decisions should be capitalized on under favorable policy, we would argue that as long-term investors we should not make short-term bets based on elections. As evidenced by the chart below, the market does not care about any of our individual political biases. Do not take it personally.
Taxes: It’s All Relative
Taxes have long been the lever that candidates pull to explain and construct their overall economic policies. Policy surrounding taxes is carefully dissected by market analyst participants since it may have the most immediate cause-and-effect.
First, some background. It is sometimes a misconception, but important to understand our tax code is set up to be progressive with regards to tax brackets. So, when you hear that Biden would restore the top 39.6% bracket from the current 37% bracket, this does not mean you will pay an extra 2.6% on every dollar you earn. For example, if the top bracket started at $400,000, every dollar earned over that threshold would be taxed at 39.6%. Every dollar below the threshold would be taxed at the rate within the specified income brackets.
We also feel it is important to address the larger picture. Most analysts expect at some point in the future, taxes will increase from where they are today. In fact, the tax cuts that were passed under the Tax Cuts and Jobs Act (TCJA) of 2017 are due to sunset and revert back to rates prior to the legislation if nothing is done by December 31, 2025. Let us look on the bright side, at least the top bracket is not 94%, as it was in 1944. Historically speaking, tax rates are low, as seen in the graph below illustrating the top tax bracket over time.
Future candidates, whether Presidential or Congressional, will have to thread the needle to the American people on the cost versus benefit of paying more taxes to support ongoing public program benefits that citizens enjoy today, like Social Security and Medicare. In a report earlier this year by the Social Security Board of Trustees, if we do nothing Social Security funds could be depleted by the year 2035, causing beneficiaries to likely take a 20% or greater cut to their current benefits. Even before COVID-19 and the subsequent stimulus, our national debt was surging. Now, Federal debt as a percentage of Gross Domestic Product (GDP) is expected to exceed World War II levels.
Where the Candidates Stand
It is necessary to set the stage of the aforementioned macro factors for comparison and context sake of current versus proposed tax policy. For the purposes of this piece, we will compare Biden’s current proposals to current tax policy.
We believe it would take a “blue wave” or Democratic sweep to have a realistic possibility of getting the former Vice President’s proposed policy amendments through Congress. Biden would need to win the White House, Democrats would have to turn at least three Senate seats, with a Vice President tie-breaker, and maintain the House for a sweep. Even then, Democrats may not be in agreement with all proposals, so policy is likely to be a compromise.
We would also be remiss not to acknowledge the virus and state of the economy as a deterrent from immediately pursuing more aggressive tax policies. This could dictate either candidate’s immediate agenda going into 2021.
Succeeding our note, we have also included a table as an appendix comparing Biden and Trump tax policies. We will highlight a few most applicable to your personal situation.
Corporate Tax Rate
Under the TCJA, the corporate tax rate was cut from 35% to 21% and does not expire (unlike the personal tax rates and estate exemption amount). The tax dollars saved fell directly to companies’ bottom lines, increasing profitability and inflating stock prices. Biden has proposed a return back to the 28% level for corporations. According to Barron’s, Biden’s tax plan would decrease S&P 500 index earnings by 8%. If the tax rate increases to a 24% level, earnings would decrease by 4%. Either scenario would decrease earnings, and in turn, most likely decrease stock prices initially.
Our Thoughts: Yes, we would anticipate an initial negative reaction from the stock market if the corporate tax rate was likely to increase. However, that does not mean we recommend selling stocks. Strong companies are resilient and will adjust. If anything, it may create a buying opportunity. We invest for the long-term; timing the market rarely works in one’s favor.
Individual Income Tax Rates
As previously mention, the current top personal income tax rate is 37% on individuals making over $518,000 and couples over $622,000. Biden’s plan will revert the top income bracket for individuals and couples back to 39.6% for high earners making over $400,000 annually. Other tax rates would stay the same.
Biden’s proposals also include a cap of total itemized deductions as a percentage of tax liability per dollar of deductions. Under current law, certain itemized deductions are capped. This implies that deductions such as state and local income tax could make sense once again for individuals in higher income tax states, which are currently capped at $10,000 annually.
Our Thoughts: This seems like one proposal that is likely to pass quickly, as the top rate reverts back 39.6% in 2026, unlike the permanent corporate rate. We expect top rates to continue to rise over time as government spending continues to increase. ROTH IRA conversions may be an applicable strategy to deploy in 2020 and pay taxes at current rates, especially with the waiver of this year’s Required Minimum Distributions passed in the CARES Act.
Investment Income Rate for High-Earners
The Biden tax plans to impose regular income tax rates on investment income, including capital gains and qualified dividends, for individuals and families earning over $1 million annually. Currently, capital gains are taxed at favorable rates, with the highest rate being 20%. Biden’s plan sets out to eliminate the preferential treatment for the highest earners, taxing investment income at ordinary rates. For the highest earners, this means going from 20% to possible 39.6%.
Our Thoughts: If you fall into the group that may have to pay ordinary rates on capital gains, we would recommend having a plan to realize some gains between November and January. Whether a sale of a business or selling appreciated stock, the difference in capital gain rates is substantial enough to fast forward a potential sale before 2021. The first quarter of 2020 allowed us to harvest some tax losses, which was an effective strategy to help offset any future realized gains.
Estate and Gift Taxes
The estate tax has become a political football more than anything else. Revenue from taxes on estates in negligible, which is included in the “Other” bucket on the chart below. However, as the wealth gap continues to widen between the rich and poor in the country, the estate tax has become a political movement symbolic of one’s stance on the broader issue.
Under the TCJA and current law, the estate tax exemption for individuals is $11.58 million ($23.16 million for couples). This means a couple could effectively transfer their wealth of up to $23 million without having to pay the hefty 40% tax on transfer. While Biden has not put a number on a proposed exemption amount, his policy recommends returning to their historical norm. That could mean an array of exemption amounts and tax rates, but would most likely reduce the amount of tax-free transfer.
Biden’s plan purposes a different approach to capture tax on generational wealth. Under present legislation, when wealth is passed due to death of a family member, inheriting beneficiaries receive “stepped-up basis”. For example, you inherit $100,000 of Apple stock from your grandmother who bought the stock for a total basis of $20,000, with an $80,000 unrealized gain. Under stepped-up basis, your basis would automatically be as of the date your inheritance, or $100,000, and therefore, no capital gain tax would be owed. As of now, details of Biden’s plan have yet to be revealed whether taxes on appreciated investments would be taxable at the decedent’s death.
Our Thoughts: First, we will continue to monitor future guidance on the “historical norm” of exemption amounts that Biden’s plan references. If your family’s estate is sizeable, or has the potential to be, we would recommend scheduling a meeting with your estate attorney in the October/November timeframe to review the current estate plan and make adjustments as necessary. There is no better time to pull together your professional team including your attorney, advisor, and accountant and we are happy to take the lead in that process. Accelerated gifting, the revocable/irrevocable nature of trusts, and life insurance coverage may all be applicable strategies going into 2021.
We cannot control election outcomes; however, we can control our reaction and realize the market’s initial reaction is not indicative of returns over the long-term. We cannot control policy, yet we can control your financial plan and investment strategy to take advantage of any opportunities in the current environment but remain flexible to anticipate future changes.
We look forward to our continued communication with you through November and year-end. Thank you for the trust your family places in us, especially during a year like 2020; we are here for you.
*Opinion piece, please see important disclosure