This quarter brought the first set of unexpected tests to the U.S. stock market since the onset of COVID-19: persistent inflation that included rising oil prices, job openings that could not be filled, supply shortages caused by manufacturing and shipping delays, the emergence of the Delta variant, the chaotic Afghanistan withdrawal, a potential debt default by Chinese property developer Evergrande echoing fears of the 1997 “Asian Contagion”, and of course, the best Congress money can buy once again playing chicken with fiscal year-end budget impasses, infrastructure spending, and fights over the debt ceiling. In response, U.S. stocks declined 5-6% over the last month, yet actually managed to gain over 4% for the quarter and returned 20% year-to-date. International markets dropped slightly this quarter and have returned just 6% year to date, while bonds are down about 1% so far this year due to rising interest rates.
Strong corporate earnings have continued to bring valuations to more reasonable levels, with the S&P 500 price-to-earnings ratio declining to 20 times earnings from 21.5 in Q2. Recessions have historically forced companies to become more efficient, but never have we seen the supply chain and labor market challenges that COVID-19 brought. The NFIB Small Business Jobs Report shows that 50% of companies currently have one or more jobs that they are unable to fill. That is staggeringly higher than the 48-year historical average of 22% of firms with unfilled positions. A rise in COVID cases along with extended government stimulus have contributed to this labor shortage, especially for parents of school-aged children.
The Federal Reserve is now expected to taper bond purchases beginning in December, with half of the 18 FOMC members expecting an interest rate hike in 2022. That timeline of raising interest rates has shortened from original expectations of 2024 as the Fed delicately reacts to an inflation rate that rose over 5% in May, June, July, and August. We’re beginning to doubt that higher inflation may be temporary, particularly since wage growth is as strong has it has been since the early 80’s.
Perhaps most impactful for our clients was the September update to the $3.5T+ “American Families Plan” tax & spend proposal from House Democrats. While the fate of the bill is a moving target, we are already monitoring how a rise in corporate and individual taxes or an increase in spending could change the outlook for the economy, markets and our clients in 2022 and beyond.
Notable Items in the American Families Plan Tax Proposal
The top tax bracket would revert to 39.6% from 37% for taxable income over $400,000 ($450,000 married). This drop from the current starting income figures of $523,600 ($628,300 married) means that some individuals and families will jump from the 35% to the 39.6% marginal bracket.
The capital gains tax rate will rise to 25% (from 15% or 20%) for those with taxable income of $400,000 ($450,000 married). This provision includes any capital gain realized on or after September 14, 2021, which eliminates year-end capital gains harvesting strategies to take gains at this year’s rates.
The Qualified Business Income (QBI) deduction will be capped for small business owners with incomes over $400,000 ($500,000 married).
S Corporation owners currently avoid the 3.8% Net Investment Income Tax. Under the proposal, business owners will have to pay the 3.8% on S Corp distributions when income hits $400,000 ($450,000 married). C Corporation taxes will rise to 26.5% (currently 21%).
The Backdoor Roth IRA and Mega Backdoor Roth IRA strategies will be eliminated in 2022. If you have after-tax money sitting in an IRA, consider converting this by year-end to your Roth IRA.
The lifetime estate tax exemption will revert back to pre-2017 levels of about $6 million per individual ($12 million for married couples) which is half of what it is today.
The child tax credit rises to $3,600 per child under the age of 6 for those under the income limits ($75,000 for single filers, $150,000 for married filing jointly).
Year End Tax Strategies
With three months to go until 2022, we want to encourage clients to consider strategies to mitigate taxes. There is an old saying “Don’t let the tax tail wag the dog.” In other words, don’t implement a tax avoidance/minimization strategy that could be detrimental to your comprehensive, long-term financial strategy. Having said that, here are a few quick reminders to consider as you close out the year:
Max out your 401(k) or 403(b) at $19,500 ($26,000 if you are over the age of 50). If you are not sure what that requires, ask for a recent paystub and work backwards to contribute the necessary amount each pay period to max out the plan.
Open or fund an individual 401(k) if you are self-employed. Deferrals are due by 12/31, while profit sharing contributions can be made prior to your tax filing deadline.
Max out your Health Savings Account (HSA) if you have a high deductible health insurance plan. Spend down your Flexible Spending Account (FSA).
Offset investment gains with losses. We will be doing this for you within the taxable accounts we manage but do make us aware if there are other gains or losses to consider outside of our view. Perform Roth conversions by 12/31 if you are in a low income tax bracket due to job loss or early retirement.
Required Minimum Distributions (RMDs) were waived in 2020 but are required in 2021. Consider qualified charitable distributions if you are over age 70 1/2. Donor advised funds may also still be used to bunch up charitable contributions for a tax deduction in 2021.
Consider accelerating income into 2021 if you have that flexibility.
For clients with large estates, family-owned businesses, etc. explore using your lifetime estate tax exemption to gift assets to beneficiaries (outright or in trust) in 2021, before the exemption comes down by half. It may also make sense to convert IRA’s to Roth IRA’s in 2021 to get both tax-free future growth and reduce the size of your taxable estate. The income tax paid now will actually reduce the size of your taxable estate..
Accelerated economic growth should continue the beginning of 2022 before moderating in late 2022. The bond and stock markets are likely to remain volatile for the next few months as Congress works through their legislative challenges, taxpayers implement year-end tax strategies in response, and supply bottlenecks and inflation either moderate or worsen.
As always, we are here to provide guidance specific to your own unique situation as we do not believe in a one-size-fits-all approach. Please contact us if you have any questions or concerns and look for additional information on year-end tax planning strategies as pending legislation evolves.