By Paul Samuelson
Between the growing hype around retail investing, eye-popping swings of value for crypto-assets, and apprehension about long-term inflation, and tax changes, the fear of missing out is having a moment right now.
More investors feel the pressure to pull the trigger on big money moves before a window of opportunity closes for good. If you believe that soaring stock and housing markets will keep climbing, you’ll want to trade up on your house or secure plum interest rates on loans. If you think tax rates are bound to increase, you might not care about taking the hit from short-term capital gains.
Seasoned investors, people who have a few market crises under their belts, have seen this movie before. They remember that almost no professional investors successfully time the markets. Housing prices can fall steeply and cause misery to borrowers. Increases in oil and food prices don’t always herald permanent inflationary increases. And it is rare that any anticipated tax increases justify paying more taxes now rather than later.
In my experience, the biggest threat to an investor’s long-term finances doesn’t come from missing the boat on a chance to beat the market. When it comes to retirement income, we have more to fear from impulsive decisions that deviate from a careful plan of investment and decumulation. I worry that novice investors may draw the wrong conclusions from our extraordinary current circumstances.
Bad Idea #1: What goes up, keeps going up, forever
It is always fun when your favorite companies post sky-high returns. If a novice investor loves Tesla vehicles or uses Zoom all day, they may be convinced they have enough insight to pick stocks. Who cares about capital gains, even short-term gains, when you can pick winners?
In the heat of the moment, it is easy to forget that high-flying stocks will inevitably fall back to earth. Buying and holding index funds, in most cases, is a better move than chasing returns or trying to time the market. Jack Bogle, the founder of Vanguard, famously preferred mutual funds over ETFs because investors were more likely to buy and hold the former and buy and sell the latter.
In fact, after the run up in stocks, many investors will actually need to sell, not buy, to stick to their target asset allocation... assuming they have one, of course. The hard truth is that no one can predict when the market will rise and fall. And no one is clairvoyant enough to reliably pick an actively traded stock that will match the pretax returns of an index fund over the long haul.
The euphoria of rising prices can hurt homebuyers as well, especially in suburbs with long commutes and in vacation destinations. How could you lose if you outbid ten other buyers by $100,000 or replace the kitchen and all the bathrooms? Investors, especially those currently working remotely, should refrain from extending themselves on a house (or a second house), especially if prices are up by 50% and employers are far away.
Bad Idea #2: Borrow and spend now before you pay for it later
After a year of lockdowns, slowdowns, and caution, consumer demand is on the rise and supply chains are struggling to keep up. High prices and product shortages may lead you to believe that the economy is taking off… and that inflation won’t be far behind.
But again, not all inflation is created equal. Long-term inflation is reflected in hikes to bond yields and borrowing rates. It also increases the effective tax rates on bonds and stocks. Investors must pay taxes on nominal returns, including real and inflationary components. Sustained inflation increases effective tax rates much more than increases in tax rates themselves.
There are far better ways for novice investors to avoid taxes over the long term. Coordination counts: brokerage accounts should be reserved for assets with the lowest tax rates: cash, municipal bonds, and index funds. High-yield bonds and actively traded stocks can be “hidden” in IRAs.
Some of the best protection from inflation comes from Social Security benefits. With enough retirement assets built up, investors can delay filing for benefits, “earning” an extra 8% on benefits for each year up to age 70. Unfortunately, most people forego this extra money by filing early: the National Bureau of Economic Research found that 56.6% of sampled retirees took IRA distributions AFTER they claimed Social Security benefits, not before.
Bad Idea #3: If you pay more up front, you won’t have to pay more later
People are fearful of tax increases even if they will never impact them. If the government wanted to deliberately encourage investor mistakes, they would periodically threaten investors with tax increases, never following through. Talk of modest increases in ordinary income taxes and large increases for long-term capital gains taxes is provoking some investors to make two mistakes:
1) Moving all their assets from their traditional IRAs and 401Ks to Roth IRAs
2) Realizing all their capital gains in the current year.
Investors can actually reduce their taxes on IRA withdrawals, by taking advantage of calendar years when they have reduced taxable income, whether that income is from earnings, Social Security, pensions, or annuities.
The novice investor should take advantage of deductions whenever possible. Think of them as a tax bracket with a 0% tax rate. Whenever possible, they should stay within brackets with low tax rates (10% and 12%) and brackets with moderate tax rates (22% and 24%). When investors empty their IRAs in a single year, they will use brackets with high tax rates (32%, 35%, and 37%).
Until investors make large withdrawals from their brokerage accounts, they can let their long-term gains on stocks remain unrealized. Without tax rate changes, they can look forward to paying only 15% rather than 20% and avoid the Medicare Investment Tax of 3.8%. Most retirees are unlikely to have more than $1,000,000 in taxable income and capital gains to ever have to pay a rate of 39% on them.
Take it from someone who has done the math: you achieve your financial goals and fund the retirement lifestyle you want by following a long-term plan, not by chasing fads and euphoric returns.
About the author: Paul Samuelson
Paul Samuelson is the chief investment officer and co-founder of LifeYield.
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