With every new president come proposals to change the tax code. And President Donald Trump is no exception.
Trump recently proposed a tax overhaul that would slash corporate taxes and individual tax brackets. Will it pass in some form or be bogged down by politics? And was the recent market plunge early last week a sign of things to come? No one knows, but the key to weathering whatever the tax code may throw at us is having different types of accounts — taxable, tax-deferred and tax-free — and investing with flexibility.
The Trump plan calls for major changes, such as reducing the number of individual income tax brackets from seven to three: 10, 25 and 35 percent. The alternative minimum tax, created decades ago so wealthy individuals don't avoid taxes, would be eliminated. Also, the 3.8 percent Medicare tax for high-income earners would be scrapped. Here's a one-page summary from the White House. While many other details aren't yet available, here is how investments could be affected if the Trump plan passed.
- Tax-free municipal bonds become less valuable due to lower tax rates, the elimination of the 3.8 percent investment income tax and the alternative minimum tax, as well as possibly limiting the amount of tax-exempt interest.
- Lower tax rates could make Roth IRAs less valuable, since the tax savings would be less.
- Complex irrevocable estate plans lose most of their value with the repeal of the estate tax but keep their complexities and fees.
Predicting what politicians will do with this plan or other legislation is harder than forecasting what the stock market will do. It's quite possible that tax rates will be much higher a decade from now to fund our ever-growing deficit. It's also possible that any of the above investment scenarios could be reversed. The more favorable long-term capital gains tax rate could be repealed. Even replacing the income tax with a consumption tax on goods and services purchased is a possibility.
The tax code is very different from 20 years ago and is likely to be very different 20 years from now. To meet this uncertainty head on, I advise my clients to diversify and to be flexible.
Having three pots of money helps diversify from the unknown changes in tax policy. I call these three tax-wrappers. Taxable money is taxed only when income is recognized. Tax-deferred accounts such as traditional IRAs and 401(k)s are typically taxed as ordinary income when the funds are withdrawn from the accounts. And money contributed to tax-free accounts like Roth IRAs and Roth 401(k)s is not tax-deductible, but is never taxed again.
The above tax treatments are under today's tax code. So when I'm asked which I recommend, I answer "all three," because tax law changes always have winners and losers. Rather than bet all your net worth on one tax wrapper, I like diversifying through all three to provide some protection. If tax rates go up, for instance, any conversion or contributions to Roth accounts may look good. But if the opposite happens, a traditional IRA account likely would have been the right choice.
The second key is flexibility. Buying something that's expensive to get out of means one can't react nimbly. For example, though municipal bonds are expensive to sell, municipal bond funds can often be sold at no cost. Permanent insurance contracts are even more expensive to exit, along with many nontraded securities like nontraded REITs. I have several clients with "irrevocable" trust accounts who can't undo what they spent thousands of dollars to create.
Anyone who claims to know the future of the tax code is suspect at best. Don't buy it.
For those with little in Roth accounts, consider a Roth conversion. This means taking some of your traditional IRA money and transferring it into a Roth. You'll pay income taxes on the amount converted, but future withdrawals — including investment gains — are tax-free.
Also, keep your investments in the accounts that are the most tax efficient for them. For instance, investments taxed at the highest rates, such as taxable bonds, are typically best held in tax-deferred traditional IRAs and 401(k)s.
Finally, keep your investments and estate planning flexible. It's the best way to position yourself for the inevitable changes in the tax code.
Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.