Back by popular demand, the next two Bernie’s BLOG posts will provide info on some great financial holiday gifts for you, your children or grandchildren. This blog will cover 529 educational plans and the next one will re-introduce many of you to Roth IRAs. By the way, we are not suggesting that you forego fun gifts for your offspring, but we really like the idea of longer term not nearly as “fun” gifts to help secure the financial futures of your lucky family members.

As many of you know, there are very few investments which grow tax-free but 529 plans and Roth IRA’s do just that, at least for now.

529 plans are state run educational savings plans which can be used for very broadly defined educational expenses for adults or children. These funds can be used for pre-college, trade school or college tuition/fees. The investments in a 529 plan can be made by anyone, subject to gift tax requirements, and are made with after-tax dollars although some states offer a state tax credit to parents who contribute in their state of residence (North Carolina does not offer this credit at this time). The funds in a 529 plan can be moved to another child and the funds do not have to be used in the state in which the plan was funded. Unlike other investments, 529 plans are controlled by the account “owner”, not by the child. Taxes and penalties are due if money is not used for educational expenses, but again, the definition of educational expenses is quite broad and usually includes computers, books, and room and board.

These plans carry low management fees because they tend to be “target date” funds where the investment mix is automatically re-balanced as the child gets closer to college age.

Although 529 plans are not LFS managed assets, we would be happy to assist you in starting one for your children or grandchildren, or even yourself! There is no minimum dollar requirement to open an account and dollars can be added throughout the year.

If you want to read up, see link below, or feel free to call us to talk more.

https://www.investopedia.com/terms/1/529plan.asp

We decided everyone could use a little laugh right now. We’ll be back to our normal dry financial stuff in December!

First of all, thanks to all of you who have checked in with us regarding the Pfizer Covid 19 vaccine trial which Marci and I are both participating in. We appreciate your interest and we did promise updates!

• The update is that all is going according to plan, at least Pfizer’s plan, as far as we can tell. Both of us are 6+ weeks past our second injection and aside from slightly sore arms and more sore bottoms from doing the long drive to the clinic several times in Atlanta traffic, we have experienced no injection side effects. And neither has anyone else we know in the trial. As a reminder, we have no idea if we got the vaccine or the saltwater placebo. With all of you, we are hoping for a positive announcement from Pfizer followed by a positive announcement from the FDA, after all the efficacy and safety data are submitted and reviewed.
• I’m sure most of you got the (exciting) email from Ameritrade announcing that the merger with Schwab is now legally complete. As we all know however, now is when the real work begins. We are continuing to be told that the systems integration will take 18 to 36 months and that there will not be any significant changes until then. We are keeping a watchful eye. And we remain committed to do whatever is required so that the work for you is minimal or non-existent during this transition. Feel free to bounce back questions. Our sense is that the Ameritrade operations team knows very little at this point, but that doesn’t mean we can’t ask questions anyway.
• And because Ameritrade has nothing else to do, they are retiring the “classic” Advisorclient.com at the end of the month. This change is to enable features which are not supported by the old technology. If you are using the old site, you will be automatically redirected to the new site. It looks different and takes a little getting used to, but the new functionality is good. And you will be able to screen share with us which will make troubleshooting much easier. None of your automatic transactions will be impacted. There is an online demonstration video and we are happy to help too.

This is obviously another very complex topic but let’s try to cover the easiest scenarios and then share what we are thinking as the election draws closer and the end of 2020 is in sight.

Disclaimer: I am sure I got some of the facts wrong so I apologize in advance for that. Feel free to correct me.

What is clear is that whoever wins the November presidential election will have a monumental job – leading the country’s economic recovery after a global pandemic which has created unemployment rates which this country has not seen in 90 years. The expectation is that once the virus is contained, the economy will quickly recover, but whether or not that is really the case, remains to be seen. For our purposes today, we will assume this is indeed true!

Of course, we must remember that whether or not any of these scenarios actually comes to pass depends in large part on whether the president’s party also controls the legislative branch, as Congress does get a say in these policies. We won’t go down the rabbit hole on this part but just recognize that this fact certainly adds additional uncertainty. There are also definitely pundits out there who believe individual income taxes will increase regardless of election outcomes, due to the level of new federal debt which has been created this year alone.

Let’s start with the scenario that Trump retains the White House as this is the easiest scenario to play out even though the full plan is still being developed.

What may happen to individual income taxes, subject to Congressional support:

• The 2017 individual income tax cuts may be extended, along with other provisions in the Tax Cuts and Jobs Act legislation, which also included an increased standard deduction and higher dependent tax credits. This Act is currently set to expire in 2025.
• Q4 employee paid payroll taxes (primarily social security) which had been deferred until 2021 may be forgiven. There is also some talk of a permanent payroll tax cut.
• Individual tax rates for middle class Americans might be reduced from 22% to 15%.
• There is talk about reducing the long term capital gains rate (which is currently 0%, 15% or 20% depending on your income) or indexing it to inflation.
• There are possible additions of tax credits tied to school choice or domestic travel.

Now let’s look at the scenario that Biden wins the White House.

What may happen to individual income taxes, subject to Congressional support:

• The components of the Tax Cuts and Jobs Act would likely be rolled back, at least for high income earners. The income tax rate for Americans earning more than $400K would go from 37% to 39.6%.
• Payroll taxes of 12.4% might be applied to earners on income over $400K, split between employers and employees. Today this tax is applied to income up to $137,700.
• Dividends and long term capital gains might be taxed as ordinary income, at a rate of 39.6%, for incomes above $1 million. Today these dollars are taxed at 20% for this set of filers. Remember this does not impact IRA’s because your RMDs are already taxed at your full tax rate.
• The step up cost basis for capital gains taxation might be eliminated as wealth is transferred to future generations.
• Tax credits for child and dependent care, earned income, children and first time home-buyers might be added/increased.

Our thoughts (with lots of input from Bernie of Bernie’s Blog fame):

The election will hopefully be decided before the end of the year so we have time to execute some tasks, but now is the time to talk about what we might want to do….

• Regardless of election outcome, a Roth Conversion is still a great strategy for those of you who have a traditional IRA and can free up some cash to pay the taxes in April 2021. As many of you know, a Roth conversion means that you convert pre-tax assets in your traditional IRA to post-tax assets in your Roth IRA. We can pick which assets to transfer so we can choose those which generate high capital gains/dividends and which may also be still recovering from the 2020 market downturn. Because these transferred assets are taxed at your full tax rate, this option is even better if Biden wins since tax rates for high income earners may increase. Many of you have already done a Roth conversion this year but there is no limit to how much you can convert, as long as you are willing to write the IRS a bigger check. If you want to do more, let’s talk about it.
• If Biden wins, you have big gains in a taxable account, and you will need cash anyway in the next 12 to 18 months, we may want to sell some of those assets this year in case the capital gains tax rate increases from 15%/20% to your ordinary income tax rate. If Trump wins, capital gains taxes might go down, so there is no income tax reason to do this year, although we will do our usual end of the year re-balancing.
• This has not been discussed yet, BUT dad believes that Biden may want to really limit Roth contributions in the future. He doesn’t believe that anyone will change the tax treatment of existing Roth accounts, but there is a possibility that the maximum income level will be reduced sufficiently that the tax benefit essentially disappears. So what that means is that if you can contribute to a Roth for 2020, you should be doing it because it might not be possible in the future. Remember that you have until April 2021 to make your 2020 Roth contribution but let us know if you want to do so we can ensure that the contribution gets assigned to the correct year.

In our last blog post we talked about the history of the Dow Jones Industrial Average (DJIA) and how the value is calculated every day. In this post, with a lot of help from WAPO columnist Allan Sloan, we will talk about what happened to the Dow when Apple split and then what the actual split, and other Dow 30 changes, mean to average investors like us. Get your calculators – or you can just trust my math!

Apple stock split

On Friday August 28, the Dow closed at 28,653.87. Over that weekend, Salesforce, Amgen and Honeywell were added to the Dow 30 and ExxonMobil, Pfizer and Raytheon were removed. Apple also split 3 for 1. And on Monday August 31, the Dow opened at, wait for it, 28,653.87. Remember that Tesla also split that weekend, BUT Tesla is not part of the Dow 30. None of these changes had any impact on the S&P 500.

Let’s look at what actually happened on the Dow:

On Friday the sum of the price of one share of each of the 30 components was $4177.68. The Dow Divisor was 0.1458. SO the closing price that day was the sum of the prices of 1 share of each stock, divided by the Dow Divisor. ($4177.68/.1458) or 28,653.87

• Next the prices of ExxonMobil, Pfizer and Honeywell were subtracted from $4177.68 and the closing prices for Salesforce, Amgen and Honeywell were added. Apple’s price was modified from $499.23 to $124.81
• When the prices for the new Dow 30 were added, the total was $4355.02. The new Dow Divisor, was then calculated to be 0.152 ($4355/28,653.87)
• Thus the closing DJIA on August 28 and the opening DJIA on August 31 were the same. The Dow Divisor moved from .146 to.152 to account for the changes and keep the DJIA constant.

So now what does all of this mean to us?

• On Friday before the stock split, Apple was by far the largest Dow 30 component at 12%. On Monday after the split, it was 3%. Because Apple has been such a hot stock, it has disproportionately impacted the Dow’s performance. On Monday, Apple gained $4.23 which moved the Dow by 28 points. If that had happened on Friday before the split, that same share price percentage increase would have moved the Dow by 116 points! Will the Dow’s growth slow due to this change? Could very well happen.
• The higher Dow Divisor should mean less volatility for the DJIA. On Monday when the Dow Divisor was higher, a $1 change in any share price moved the DJIA by 6.58 points. On Friday when the Dow Divisor was lower, that same $1 share price change moved the market by 6.86 points. Given the world we live in right now, we will take less market volatility any way we can get it.
• One of the stated reasons that companies undergo a stock split is to make their shares more accessible to average investors. Presumably more investors can afford a $125 share price rather than a $500 share price. While this is technically true, the vast majority of shares are owned by institutional buyers (mutual and pension funds) who are not worried about such mundane things. Additionally more brokerages are now offering partial share purchases to help investors buy some of these high priced individual stocks. Although pundits are split about equally on whether stocks go up or down after a split, this could be a good opportunity to buy some gift shares for your children or grandchildren.
• For any investors who own one of the two ETFs which track the Dow, this change triggers significant buying and selling of equities to match the new Dow. Luckily, ETFs are relatively tax efficient, so these changes should be inconsequential unless the ETFs are sold shortly after a major update.

Some of you have asked us this question over the last month so we finally decided to answer it. The real answer is a bit complicated but also quite interesting – in a geeky financial advisor sort of way. I learned a few things while I was researching this topic so hope you will too!

Now, before I get to that actual answer, we need to start with some information on the Dow Jones Industrial Average – yes, you are reading this right – which we will do in this post. And then we will actually attempt to answer the question in the next post.

Spoiler alert, you may need a calculator.

A bit of history and math: the Dow Jones Industrial Average, aka DJIA

The DJIA is comprised of 30 large publicly owned companies which trade on the NYSE and the NASDAQ. It is designed to serve as a proxy for the broader economy. When people refer to the “stock market,” they are most often referring to the DJIA. As the economy changes and industries or companies become more or less relevant OR the price gets too high or too low (more on that later), the Dow composition changes. In fact the composition has changed 60 times since 1928! In late August, Salesforce, Amgen and Honeywell were added to replace ExxonMobil, Pfizer and Raytheon. (GE was replaced in 2018.) And of course Apple shares split at the same time.

Trivia alert:

1884 Original 12 DJIA stocks: American Cotton Oil, American Sugar, American Tobacco, Chicago Gas, Distilling & Cattle Feeding, General Electric, Laclede Gas, National Lead, North American, Tennessee Coal & Iron, U.S. Leather pfd, U.S. Rubber

August 2020 DIJA stocks: 3M, American Express, Amgen, Apple, Boeing, Caterpillar, Chevron, Cisco, Coca Cola, Dow, Goldman Sachs, Home Depot, Honeywell, IBM, Intel, Johnson & Johnson, JP Morgan Chase, McDonalds, Merck, Microsoft, NIKE, Procter & Gamble, Salesforce, The Travelers Company, United Health, Verizon, Visa, Walmart, Walgreens Boots Alliance, Walt Disney

OK here is where the math comes in. Unlike the S&P 500 and other indexes which are market cap weighted, The DJIA is price weighted. That means that in the S&P 500, the largest companies have the most weight. In the DJIA, the companies with the most expensive share price have the most weight. This is why the Dow is very careful to avoid adding stocks which have very high prices – they will have a disproportionate impact on the average. Apple was added in 2014 after its 7 for 1 stock split. This also explains why Amazon probably will not be added anytime soon! Although this price weighting has its share of critics, and seems a bit silly to us now, in the late 1800’s when the DJIA was formed, share price was the only easy/possible thing to measure in real time. In truth, the Dow has actually performed eerily similarly to the Wilshire 5000 which is the largest U.S. stock index.

So how is the DJIA calculated?

The “Dow 30” is calculated every day by adding the price of one share of each of the component stocks, divided by the “Dow Divisor.” The Dow Divisor is just a mathematical constant designed to determine the effect of a $1 move in any of the 30 stocks. Obviously we wouldn’t need this complication if stocks never split, companies never merged or declared dividends, or there were no changes to the 30 stocks in the Dow 30. But that would just be too simple!

Dow Jones Industrial Average = sum of price of 1 share of each stock on Dow 30 divided by the ”Dow Divisor”

and of course

“Dow Divisor” = sum of price of 1 share of each stock on Dow 30 divided by the Dow Jones Industrial Average

We won’t attempt to understand or explain the Dow Divisor calculation, but just know that the Wall Street Journal has the job of ensuring that the Dow Divisor is appropriately adjusted to ensure that historical accuracy of the DJIA is maintained, regardless of market changes.

The current Dow Divisor is 0.146. Let’s just accept this, even though it feels like a circular argument!

The important part is that with this Dow Divisor value, every dollar change in price of any Dow 30 stock results in a DJIA change of 1/0.146 or 6.8 points.

Clearly, the most expensive stocks have the most influence on the average. And prior to its split, Apple was by far the most expensive and also fastest growing stock in the Dow.

Next up: So what did the Apple split do to the Dow and what does that mean for average investors like us?