Quarterly Update
A common topic in our newsletters these past couple of years has been how steady and positive the markets have been over this time. We have cautioned against expecting that to continue into perpetuity, and we saw a chink in the armor this past quarter. Since the first quarter of 2020 and the start of the pandemic, there had not been a single down quarter. Starting in September, we finally saw some volatility. September has consistently been the worst month for US stock returns, historically. From 1926 through 2020, it has been the only month to average negative returns. However, overall, the markets have continued their run-up. The Dow rose from 18,000 to 34,000 over the past year and a half.
Uncertainty is a fundamental cause of market swings – we tell clients often that the markets crave certainty. We believe that several recent headlines have been a cause of short-term volatility, but that this doesn’t signal a fundamental change in the economy. There are many headlines that have contributed to this volatility over the past few months.
In September, news broke that Evergrande, a Chinese real estate developer, was having difficulty managing its massive debt load. Evergrande is one of the Global 500, the worldwide businesses with the highest revenue, so its potential default could potentially spread outside the Chinese markets. As various deadlines loom, this is a test of whether China will continue its historic pattern of intervening to prop up businesses.
Inflation continues to be a big topic, although overall we remain confident that it will stay within a normal range. Since the early 1990s, inflation has stayed remarkably steady. Four main influences have caused inflation to rise recently:
Policy: The Federal Reserve tries to target a yearly inflation of 2%. Following a period where it was significantly below that, like last year, it will often allow that number to go above 2% to get back on trend.
Fiscal Boost: The huge stimulus packages passed in 2020 amounted to roughly double the loss of GDP due to the pandemic, close to 25% of 2020 GDP.
Pent-Up Demand: Consumers haven’t been able to spend freely due to the pandemic’s restrictions. The result is a jump in the US personal savings rate from a low of 8% pre-pandemic to a 20.5% in January.
Rising Production Costs: As companies seek out ways to eliminate or reduce supply chain concentration in one area of the globe, production costs could move higher as industries consider more than just the lowest-cost options. (Blackrock: Student of the Market: Inflation Edition)
Another common question we get is regarding the potential for another government shutdown. At this point, the Senate looks like it has reached a deal to avoid a government shutdown until at least December 3rd. We have had 22 funding gaps in the federal budget since 1976, ten of which have led to federal employees being furloughed. The most significant shutdowns in the US occurred in 1995-1996 (21 days), 2013 (16 days), and 2018-2019 (35 days). We believe this issue will flare up again in late November, but ultimately will be solved. As we have discussed in recent newsletters, more than the overall size of the nation’s debt, the primary concern of most investors and economics is how much it costs to make payments on it. Due to low interest rates, these will be historically low over the next few years – the lowest since the 1960s, as a percentage of the overall size of the economy (Bloomberg: The Real Cost of U.S. Debt is Nearer the Floor Than the Ceiling).
Perhaps the most significant headline in recent weeks aside from the debt ceiling has been the Biden spending plan and its funding via changes to the tax code. When those changes will take effect and precisely what they will be are still being debated, but we wanted to provide a general summary of what seems likely at this time.
The spending plan is now composed of two bills. The American Jobs Act provides $2.2 trillion of funding – $1.7 trillion of which is geared toward infrastructure, including transportation, school buildings, broadband internet, the national electric grid, and clean drinking water – and is funded by increases in corporate tax rates. One major component is raising the statutory corporate tax rate from 21% to 26.5%.
The American Families Plan is currently sized at $1.8 trillion and would fund social programs such as universal pre-k, paid family and medical leave, an expanded child tax credit, and two free years of community college for household incomes under $125,000. It is funded by changes to the tax code for individuals, which we’ll address in detail below, thanks to a great writeup by Jeffrey Levine and Michael Kitces.
Note: for all items below, the term “high-income filers” for a proposed change always refers to single filers making $400,000 or more and joint filers making $450,000 or more.
For filers making $400,000 or less, income tax rates stay the same. Currently, the top rate is 37% and taxes effect for single filers making $523,600 and married filers making $628,300. The plan returns the top ordinary income tax rate from 37% to 39.6%, reversing the tax cut enacted in 2018, and lowers the bracket itself. As proposed, the 39.6% rate would now apply to high-income filers – single filers making $400,000 and married filers making $450,000 or more. It would go into effect beginning with the 2022 tax year.
For filers making $400,000 or less, capital gains tax rates stay the same. Currently, the top rate is 20% and takes effect for single filers making $445,851 and married filers making $501,601 or more. As proposed, the top rate would now be 25% and take effect for our new definition of high-income filers. This change would be retroactive to September 14, 2021.
Backdoor Roth IRAs and the Mega Backdoor Roth would be prohibited starting in 2022. This applies to filers with income too high to make regular Roth IRA contributions. In addition, Roth conversions would be banned for high-income filers starting ten years from now, in 2032.
Certain high-income S corporation owners may become subject to a new surtax of 3.8%. Currently, S corporation profits are not subject to either employment taxes or the Net Investment Income Tax. As proposed, S corporation profits would be added to other investment income to create a new ‘Specified Net Income’ amount, and the greater of that or their net investment income would be subject to the 3.8% surtax. This applies to single filers making $400,000 or more and married filers making $500,000 or more.
Filers with income of over $5,000,000 would be subject to an additional 3% surtax.
Several proposals are under consideration to modify Required Minimum Distributions for high-income filers who have $10 million or more in retirement accounts.
Several changes to estate planning provisions have been proposed as well. Most notably, the estate and gift tax exemption amount was doubled in 2018 to $10 million, and that provision was due to sunset in 2025. As proposed, this would go back to $5 million in 2022.
As always, while we tried to keep our summary to the most relevant proposals, we are keeping a close eye on all provisions within the proposed legislation. Any time we see big changes on the horizon like this, for clients who are likely to be affected it’s a good time to discuss with your core team: your estate planning attorney, your CPA, and our office.