In recent years, many savers have enjoyed high returns on cash holdings due to elevated interest rates set by the Federal Reserve (Fed). However, with the Fed's recent rate cuts and
the impending expiration of the Trump tax cuts at the end of 2025, financial advisers are warning that savers may face both lower yields and higher taxes. This article provides a
comprehensive guide on how individuals can adapt their savings and investment strategies to mitigate these challenges.
The Trump Tax Cuts: A Brief Overview
The Tax Cuts and Jobs Act (TCJA) of 2017, often referred to as the Trump tax cuts, was one of the most significant overhauls of the U.S. tax code in three decades. Among its key
provisions were widespread reductions for businesses and individuals. For individuals, these changes included:
- Lowering the top income tax rate from 39.6% to 37%
- Reducing rates across multiple brackets:
- The 33% bracket dropped to 32%
- The 28% bracket dipped to 24%
- The 25% bracket slid to 22%
- The 15% bracket fell to 12%
If these tax cuts expire as scheduled at the end of 2025, income taxes will revert to their pre-2017 levels. This could significantly impact an individual’s disposable income and
investment returns.
Falling Interest Rates: A New Reality
The Fed has recently cut interest rates to stimulate economic growth by making borrowing cheaper for businesses and consumers. Banks respond to these cuts by lowering the interest
they offer on savings accounts, certificates of deposit (CDs), and money market accounts. This means that savers will earn less from their cash holdings than before.
For example:
- If you had $100,000 in a high-yield savings account earning 2% annually, you would now earn $2,000 per year.
- With interest rates falling to 1%, the same amount would yield only $1,000 annually.
Strategies for Adapting Your Savings and Investment Plans
To mitigate the effects of both lower yields and higher taxes, consider the following strategies:
Accelerate Income Before Tax Hikes
One effective strategy is to accelerate income into years with lower tax rates. This can be particularly beneficial if you expect your future tax bracket to rise.
- Retirees: Consider withdrawing slightly more than your required minimum distribution (RMD) in 2024 and 2025. By doing so, you can take advantage of the current lower tax rates
before they increase.
Roth IRA Conversions
Converting traditional IRA funds to a Roth IRA can be advantageous if you expect higher taxes in the future.
- Process: You pay income taxes on the amount converted at your current rate but avoid paying future taxes when making withdrawals from the Roth IRA.
- Benefits: If tax rates rise, this conversion strategy allows you to lock in today's lower rates and benefit from tax-free growth going forward.
Move Cash to Stocks
With interest rates falling, many financial advisers recommend shifting funds into stocks for potentially higher returns. While this involves more risk than traditional savings
accounts, it can be a viable option if managed carefully.
- Risk Management: Advisers often suggest diversifying through mutual funds or exchange-traded funds (ETFs) rather than investing solely in individual stocks.
- Focus on Small and Mid-Sized Companies: These companies may benefit more from lower borrowing costs and could offer better investment opportunities compared to larger firms.
High-Quality Dividend Growth Stocks
For those needing regular income, especially retirees, focusing on dividend growth stocks can be a strategic approach.
- Key Considerations:
- Look for companies with annual dividend growth rates of 7% to 10%, yielding around 3.5% to 4% annually.
- Ensure the dividends grow at or above inflation to maintain purchasing power over time.
Tax-Efficient Dividend Investing
When investing in dividend stocks, it’s important to consider tax efficiency:
- Qualifying Dividends: These are taxed at lower capital gains rates if held for more than a specified period (usually 60 days within the holding period).
- Regular Income: Non-qualifying dividends and short-term capital gains are taxed as ordinary income.
Conclusion
The combination of expiring tax cuts and falling interest rates presents significant challenges for savers and investors. However, by strategically adapting savings and investment
plans, individuals can navigate these changes effectively. Key strategies include accelerating income before higher taxes take effect, converting to Roth IRAs, moving cash into
stocks, focusing on dividend growth stocks, and prioritizing tax-efficient investing.
By staying informed and proactive, you can position your finances to thrive in the evolving economic landscape.
