The year-end process can be stressful for many investors and 2021 is no different in terms of having proposed changes to the federal tax code. The proposed Build Back Better Act is currently structured to limit those who can use the “Backdoor Roth” strategy.  While we don’t know if this bill, in its current form, will become law, but here are some considerations.

The Backdoor Roth Strategy

The Backdoor Roth strategy is a way for high wage earners to make contributions to a Roth IRA, even if they are above the income threshold to make direct Roth contributions.  The way the backdoor Roth strategy works is that an investor makes a non-deductible (after-tax) contribution to an empty Traditional IRA and then immediately makes a Roth conversion for the amount of the contribution. There is no income limit for making non-deductible contributions to a Traditional IRA and since they contributed after-tax money, there’s no tax impact on the conversion.

This is a great strategy that we recommend for all high wage earners who are already maximizing pre-tax contributions to employer plans and do not have existing pre-tax assets in a Traditional IRA.

What’s proposed?

Under current tax law, an individual with a modified adjusted gross income (MAGI) equal to or greater than $140,000 or a married couple filing jointly with a MAGI equal to or greater than $208,000 can’t contribute directly to a Roth IRA.  However, anyone, regardless of their income, can use the Backdoor Roth strategy. If the Build Back Better Act is passed into law, single filers with a MAGI of $400,000 and joint filers with a MAGI of $450,000 will no longer be able to use the Backdoor Roth strategy. If passed, this change would become affective starting Jan 1, 2022.

What does this mean for you?

If this act goes into law, there will be three distinct groups and savings strategies based on modified adjusted gross income (MAGI):

 

  • MAGI less than $140,000 (single) or $208,000 (married filing jointly)

Recommendation: Standard Roth IRA contribution

 

  • MAGI $140,000-$400,000 (single) or $208,000-$450,000 (married filing jointly)

Recommendation: Backdoor Roth IRA contribution

 

  • MAGI greater than $400,000 (single) or $450,000 (married filing jointly)

Recommendation: Alternative savings vehicle, such as recurring contributions to an after-tax brokerage account.

 

This act has not yet been passed, but we want our clients to be prepared if it becomes law. If you have any questions about the Backdoor Roth strategy or the proposed changes, don’t hesitate to reach out to your advisor or schedule a call.

GameStop has been in the news in the last week as the share price jumped from $35 to $350, and is up from an April intraday low of $2.57. There are lots of things going on with this but the one getting the most attention is the “short squeeze.” We’re going to describe what a short is, what a short squeeze is, and how it’s playing out with GameStop.

A short is a bet on a stock decreasing in value. In an effort to improve market efficiency and for some to hedge risk, the SEC allows certain individuals to sell a share of a stock that they don’t really own. For example, say investor A owns $100,000 of Apple, and they plan to hold it for at least a year. Meanwhile, speculator B thinks Apple is overvalued and will go down over the next year. A & B can enter an agreement where B borrows the shares A owns with the promise to give those shares back in one year, plus $1,000 for providing the shares.

Investor A likes this because they will end up with the same long position and they make $1,000. B likes it because B can now sell those shares in the market. Because B has temporarily borrowed these shares and has locked in a value to give them back, they don’t really have exposure to Apple. When B sells the Apple shares on the open market, they now own negative Apple, which is called “being short.” Because B must give A back the shares in a year, B is betting that Apple will go down in value allowing them to buy Apple back at a lower price a year from now.

In our example, if Apple’s price drops in half, B can buy back the Apple position for $50,000. B received $100,000 for selling the borrowed Apple at the start of the year so B nets $49,000. However, if Apple goes up 50% and B has to buy the shares back in a year it will cost B $150,000, for a loss of $51,000.

Shorting a stock is risky for two reasons. Stocks, in theory, have no maximum share price, so there is no limit to the amount of loss one can incur from shorting a stock. The other reason is that stocks as a whole have always gone up over time. The efficient market theory would say engaging in a short position has a negative expected return.

A Short Squeeze is when speculators who have shorted a stock are forced to “cover” their short by buying back the stock. This can lead to a snowballing effect where buying fuels more buying, driving the price of the stock higher. For example, a speculator who is renewing a short on a daily basis may suddenly have the lender decide they don’t want to lend anymore and asks for the share back. Alternatively, the lender of the stock may require the speculator to post margin based on how much the position has moved against the speculator. At some point, if it’s moved so much that the speculator no longer has the cash margin, the speculator will be forced out of the position. Either way, the speculator must buy shares, driving the price up.

There is another phenomenon, called a gamma trap, that is sparked by a different type of speculator who likes the stock. If that speculator buys a call option on the stock, the wall-street trading desk that wrote the option may hedge their position by buying the stock in the open market. If enough speculators are buying calls, that will drive the price higher, which in turn fuels more hedging by the options desk (people describe this in terms of delta and gamma). This is a way for a speculator to magnify the effect their dollars have on the price of a stock. This coupled with the short squeeze can create a cycle of buying that becomes self-fulfilling.

GameStop has become an incredible case study in short squeezes. 10 years ago, GameStop had about $9.5 billion in revenue and was making $400 million a year. Today, GameStop has $6 billion in revenue and is losing about $400 million a year. The book value of equity has shrunk from $3 billion to $600 million. As COVID-19 reduces retail foot traffic and more video games are downloaded directly from the publisher or from companies like Steam and Origin, you can understand how some would speculate the company’s stock will decline.

As a result, many hedge funds and other “Wall Streeters” have shorted GameStop. In fact, so many have shorted the company that the number of shares shorted exceeded the total number of shares available for trading (yes that is possible). This had been effective and lucrative as GameStop’s share price steadily declined from $30 in 2016 to about $4 for most of 2020 (at $4, GameStop has a market capitalization of $280 million).

However, a new board member and an internet forum have shifted the sentiment. What started as a fundamental case for a higher valuation turned into an internet movement to beat Wall Street at their own game. At this moment it looks like the internet trolls are winning. Those who bought GameStop last Friday have seen the share price move from $50 to $350 as of today’s close ($24.5 billion valuation). Meanwhile, short sellers have either taken an enormous mark to market loss or locked in an enormous loss as they’ve exited their position.

The Wall Street Journal reported that hedge fund Melvin Capital is down 30% this year due to shorting companies like GameStop. With $13 billion in assets, that amounts to a loss of nearly $4 billion for the speculators who outsourced their speculating to Melvin.

Where we head from here is anyone’s guess. The $350/share at today’s close could be a stop on its way to $1,000+, it may also be the all-time high. At some point in the future, emoji-filled internet commenting will return to normal, short selling will stabilize, and GameStop’s share price will return to the present value of expected future profits. $25 billion seems high for a company struggling to break even with $6 billion in revenue and no expected revenue growth, but turn arounds do happen and the press around the stock may help drive sales. It will be up to management to try and make that boost permanent rather than temporary, which will be a difficult task.

I see a few glaring takeaways. First, this isn’t investing, it’s playing a game. Providing capital so a company can produce a good or service and generate wealth for society provides an expected return for an investor. Shorting a company, or trying to squeeze a short, or buying options, does not generate wealth and does not come with an expected return. As every trade has a bid/ask spread, you must win a little more than half the time just to break even and the sum of all players is negative.

It’s also a reminder of why paying a lot for active management is a bad idea. While those who gave their money to Melvin are down 30% in 2021, the owners of Melvin are up 0.16% this month because they charge a 2% management fee. Paying 2 & 20, or even 1% for active management is unlikely to benefit you. Remember, the average of all investors, not including management fees, is the market average. Math dictates the majority of active management must underperform a low-cost fund after taking into account the fees they charge.

Lastly, if you want to buy an individual stock (which Rockbridge doesn’t recommend), do so because you plan to hold it for many years. Buying a company now because you think you think it will make you rich later today or next week is not a prudent way to manage your money.

As others speculate on things they can’t control like the price of GameStop’s stock, instead focus on things you can. Are you taking full advantage of your 401(k) or Roth IRA this year? What about a 529? Do you have enough term life insurance? Do you have any 1099 income that can be saved in a self-employed retirement account? Do you feel comfortable with your Social Security claiming and portfolio distribution strategies in retirement? Reach out to your Rockbridge advisor so we can make sure you’re on the right path in these areas and don’t worry about GameStop, which has fallen 31% to $240 as I type this…

Congress created the Paycheck Protection Program (PPP), to provide liquidity to small businesses dealing with the effects of the economic shutdown.  It was clear from the language in the CARES Act that loans used for covered expenses would not be included in a business’ gross income. However, the Bill was silent on the deductibility of these covered expenses. The IRS recently released guidance taking the position that allowing businesses to deduct expenses paid with tax exempt income (the PPP loan) would provide a “double tax benefit.” Now, after many small businesses have taken loan money in order to continue paying their employees, make rent, or cover utility costs, they face the possibility that they will not be able to deduct these expenses if their PPP loan is ultimately forgiven.

Lawmakers from both sides of the aisle are critical of this position and are proposing legislation that would override the IRS on this issue. Senators John Cornyn, R-Texas, Charles Grassley, R-Iowa, Ron Wyden, D-Ore., Marco Rubio, R-Fla., and Tom Carper, D-Del. proposed the Small Business Expense Protection Act, an amendment to the CARES Act which would allow covered expenses to be deductible.

A separate piece of legislation enacted by The House of Representatives, called the Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Act, also addresses the deductibility issue. In addition to correcting the deductibility issue, the HEROES Act would allow employers receiving loan forgiveness under the PPP to take advantage of the CARES Act’s payroll tax deferral provisions, which was prohibited in the CARES Act.

So where does this leave small business owners who are wondering how to account for these PPP financed expenses? Unless Congress passes or negotiates a fix, they will have to assume that they will not get both loan forgiveness and the ability to deduct the expenses paid for with loan proceeds. This could ultimately mean companies may need to make larger than anticipated estimated tax payments by July 15th. Hopefully Congress will act swiftly to settle this issue so that business owners can turn their attention to safely reopening as soon as they get the green light to do so.

In order to provide the best advice to our clients, we pay close attention to updates and guidance on the various CARES Act provisions, including the PPP. As soon as we know more, we will release a follow-up article with the latest information and impact to small business owners.

 

The IRS is extending the federal income tax filing deadline to July 15 as part of a growing effort to stem the financial pain from the coronavirus pandemic, Treasury Secretary Steven Mnuchin announced Friday.

The move gives Americans three months more than they normally would have to file their income tax returns for the 2019 tax year, without incurring interest or penalties.

President Donald Trump later Friday said that “hopefully” by the time the new deadline arrives “people will be getting back to their lives.”

“At @realDonaldTrump’s direction, we are moving Tax Day from April 15 to July 15,” Mnuchin wrote in a tweet about the extension.

“All taxpayers and businesses will have this additional time to file and make payments without interest or penalties,” he wrote.

Trump echoed that suggestion during a White House press conference.

Most Americans are entitled to refunds when they file their federal tax returns.

As of March 13, the Internal Revenue Service had issued 59.2 million refunds out of the 76.2 million million individual income tax returns it had received, or 77.7% of the total number of returns filed by that date.

The average refund check was $2,973, according to IRS data.

Many individual states already had extended their own tax filing deadlines to various dates to give people relief from the financial fallout of the coronavirus outbreak, which has shuttered businesses nationwide and led to large-scale layoffs.

The IRS move will increase pressure on states to align their deadlines with the new one for federal income tax returns.

New York Gov. Andrew Cuomo, asked at a press conference if state residents should pay their state income taxes by the New York deadline of April 15, said the new federal guideline should be followed.

The IRS did not immediately return a call for comment from CNBC. It is not clear if the deadline extension also will include the deadline for funding Individual Retirement Accounts for the 2019 tax year.

A proposal to extend the federal filing deadline to July was included in the Senate’s coronavirus economic stimulus bill, which was released Thursday by Majority Leader Mitch McConnell, R-Ky.

That proposed relief package calls for new federal spending that could top $1 trillion.

Earlier this week, the Treasury Department released guidance that would have pushed back only the deadline for making federal tax payments — not for filing tax returns —  to July 15.

That 90-day reprieve on payments would have applied to 2019 income taxes owed, plus first-quarter tax payments that would have been due on April 15.

Federal lawmakers and members of the tax preparation community had criticized the proposal to have different dates for filing tax returns and making payments. Mnuchin’s announcement ends that debate by having returns and payments each due by July 15.

The White House declined to comment on Mnuchin’s announcement.