President Donald Trump’s great Christmas gift to Americans may benefit him and other wealthy people the most, but that doesn’t mean middle-class investors can’t take advantage of the tax reform to improve their financial health.
The average taxpayer will save $2,940, according to the Tax Policy Center. Middle-income households can expect tax savings of $1,010. That may not seem like much, but invested in stocks over time that $1,000 can turn into tens of thousands of dollars. “The tremendous advantage to investing tax savings is that you don’t have to change your lifestyle to do so; you can simply act like you didn’t get any tax savings,” says Robert Johnson, president and chief executive officer of The American College of Financial Services in Bryn Mawr, Pennsylvania.
Before you blow your tax savings on a new pair of shoes, consider putting the money to work for a longer-lasting reward, such as paying down debt or building future wealth. If you’re able to stash your tax savings every year and limit your debt burden, “you’ll be in a great position to build wealth over time,” says Brandon Frank, assistant vice president of the savings portfolio at Navy Federal Credit Union in Vienna, Virginia. Because the benefits won’t last forever — most tax rates will revert to their original levels in 2026 unless further legislation is passed — there’s all the more reason to make the most of your tax savings each year.
[Read: 5 Ways to Boost Retirement Savings in Your 20s.]
Address your most pressing needs first. Use “this as an opportunity to contribute to your most pressing needs, whether liquidity, longevity or legacy,” says San Francisco-based Kimberly Twombly, first vice president of wealth management at UBS Financial Services. If you don’t have enough short-term savings, use a tax reform windfall to build up an emergency fund. If you’re worried about outliving your long-term savings, add the windfall to a retirement account. If you want to leave a legacy, this is your chance to start or supplement your estate plan.
Lule Demmissie, managing director of investment products and retirement at TD Ameritrade, says the question of where to use your savings is about who you want to pay today: your current self or your future self? “That’s sort of unorthodox because most people would tell you to put it all toward your future self,” but “sometimes paying a little bit to our current selves can help prevent us from raiding our savings,” she says.
There’s a reason people tap their retirement when times are tough. “We never want to put people in a position where they’re so strapped they’re endangering things they shouldn’t touch,” Demmissie says. So, first, “take care of things that could jeopardize your future financial health,” like paying down debt or replenishing your short-term savings accounts. Once those immediate concerns are addressed, you can look into investing your savings.
Leverage the power of compounding with higher-returning investments. Where you invest is governed by when you will need those funds and how you react to volatility. “If you don’t think about those things, you may end up investing in something that could be a good long-run investment, but because you didn’t have the patience [or risk tolerance required], you got burned,” Demmissie says. If you only have a few years to invest or think you might panic sell if the market declines, for example, steer clear of stocks.
A safer option is a certificate of deposit, Frank says. CDs generally provide higher rates than basic savings accounts without exposing investors to market risk. But they do require locking up the funds for a specified period or paying an early withdrawal penalty.
For the vast majority of investors who can tolerate market volatility, “the best investment is a diversified portfolio of common stocks,” Johnson says. “And the reason is compounding.” The rate at which your investments compound is determined by your annual return. “The higher the annual return, the greater the power of compounding,” he says. The average annual return for large-cap common stocks since 1926 is 10 percent, according to Ibbotson Associates. Meanwhile, bonds returned about 6 percent and cash only 3 percent during that period. In 40 years, $1,000 earning 10 percent compounds to more than $53,000; earning 6 percent, it becomes nearly $11,000, and at 3 percent, it’s a miserly $3,315.
[Read: The Best Guide to Mutual Funds.]
Diversify with mutual funds and ETFs, but watch out for those fees. That said, four out of seven stocks return less than one-month Treasurys over a lifetime, according to a study by Arizona State University professor Hendrick Bessembinder.
Only 4 percent of all common stocks listed on the New York Stock Exchange, American Stock Exchange and Nasdaq accounted for all stock market gains since 1926, he finds. “In other words, the returns on the market have been driven by a small percentage of big winners,” Johnson says. But “trying to pick winners, for most, is a loser’s game.”
The safest route to accumulating long-term wealth is to invest in diversified mutual funds or exchange-traded funds that track a broad market index, he says. With an index fund, you can earn the average return of the broad market while paying minimal fees. “Low fees means more of your money works for you, and over time, that’s extremely important,” he says. “Just like returns compound, the negative impact of fees compounds over time.” He points investors toward the Vanguard 500 Index Fund (ticker: VFINX), which has an expense ratio of 0.14 percent.
Use tax-loss harvesting to save more on taxes next year. “As people’s tax profiles are changing in this new tax policy, every tool they have to reduce their tax burden is useful,” Demmissie says. If your tax cut this year isn’t as much as you hoped for, consider tax-loss harvesting strategies for bigger savings next year.
Tax-loss harvesting enables investors to use investment losses to counteract future taxes on capital gains and income. The strategy harvests, or realizes, losses before reinvesting those proceeds into similar securities to preserve the asset allocation.
[Read: How to Lessen the Bite of Taxes.]
TD Ameritrade recently launched an automated service that will monitor portfolios daily for tax-saving opportunities and harvest losses as they appear. The service is free but has an entry point of $5,000 per account.
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Make the Most of Your Trump Tax Reform Savings originally appeared on usnews.com
