What Do the Possible Changes to Personal Income Tax Mean for Your Financial Plan?
Over the past weeks, we have glimpsed some of the proposed changes to the current individual income tax structure. Our team is committed to proactively helping you understand what this means for your financial plan, and we are pleased to share our initial takeaways.
What is on the table so far?
We see three primary changes that may impact your financial plan and Investment Policy Agreement.
- The proposed elimination/reduction of state and local income taxes. In an effort to be more “tax neutral,” the purposed changes include removing these popular deductions in exchange for lowering the top rate. While there is still discussion around full elimination of the deduction or simply a phase-out, this will be significant for those living in high property tax regions in Philadelphia and the New Jersey suburbs, as well as those who own property on the New Jersey Shore. Full elimination of those deductions could make any cut in the top rate irrelevant.
- The proposal advocates corporate taxes to drop to 20% and proposed tax holiday to repatriate assets U.S. companies are keeping in foreign countries. While the rate may not drop that low, we believe any reduction will be supportive of corporate profits. We are more optimistic on the trickle-down effect from repatriation. A one-time 10% tax holiday has been proposed, and this year has been quiet in terms of M&A activity. The largest technology, pharma and biotech companies are keeping billions of dollars abroad to avoid paying taxes. Our team believes that even if a portion of those funds return domestically, these companies will be motivated to acquire smaller companies, invest in new research and development, and raise dividends. This could be more beneficial to owners of financial assets, as we believe the markets would benefit from this fiscal stimulus.
- The collapsing of the current tax rate system to three income tax rates: 12%, 25% and 35%. There is also a proposed repeal of the alternative minimum tax and federal estate tax. The greatest benefit we see here is simplification of the current tax system. The proposal would also nearly double the standard deduction to $24,000. This may be seen more favorably by those who currently have itemized deductions that do not equal that dollar amount.
What does this mean for your financial plan?
While there are still questions to be answered and details to unfold, we believe there are some fundamental planning considerations for families with accumulated financial assets.
- Tax efficiency in your plan is still paramount. While accelerating deductions in 2017 that may be worth less in 2018 merits some consideration, most taxpayers in a 35% tax bracket or higher may be in a similar net taxable position despite lower rates. The main reason is the removal of property taxes, state and local income taxes, as well as other commonly itemized deductions, may more than offset a lower tax rate. The benefits of double tax-free municipal bonds, tax-efficient equity strategies and converting ordinary income tax liability to capital gain tax liability will likely be as important in 2018 as they are now.
- Proactive, year-long tax loss harvesting. To derive the benefit of a capital loss to offset a capital gain, accelerate the unrelated loss to realize and replace the investment with a similar investment to maintain the portfolio allocation. This strategy allows you to benefit from the loss without triggering the wash sale rule. This rule states if you sell a security at a loss and purchase an identical security within 30 days, your loss is disallowed. Capital losses are carried forward and offset capital gains and also can be used to offset ordinary income up to $3,000. The wash sale rules are detailed, and this strategy should be employed in coordination with your advisor.
- Asset location is as important as asset allocation. Dividends carry a maximum tax rate of 23.8% (20% dividends rate plus the 3.8% NII surtax on investment income), while ordinary income tax rates may be as high as 43.4% (39.6% ordinary income tax rate plus the 3.8% NII surtax on investment income). The lower tax rate on dividends suggests placing higher dividend-paying securities in taxable rather than tax-deferred accounts. Investors lose the opportunity to defer current taxes on these dividends, but it may be preferable to paying the ordinary income tax rate when taking distributions from tax-deferred accounts. With the maximum long-term capital gains rate at 20%, it may be appropriate to hold long-term property in taxable accounts and short-term (actively managed) property in tax-deferred accounts. If dividend and capital gains rates increase in future years, this strategy may need to be reconsidered. Investments that generate higher tax liabilities, such as high ordinary income generating investments, may be appropriate to hold in tax-deferred accounts.
- Consider using low-cost basis securities or your required distribution from your IRA instead of cash for charitable giving as well as to loved ones in a lower tax bracket. The fourth quarter is often a time when philanthropic giving is done in tandem with tax planning. More high-income wage earners than ever are going to find themselves with the dual challenge of paying a higher level of capital gains tax and receiving less tax benefit from charitable giving due to the previously mentioned phase-out of itemized deductions. A win/win can be accomplished with a careful review of your taxable investments to see where you may have significant unrealized gains. These low-cost basis securities can be gifted to a charity who can sell the security tax-free. Your charitable contribution is the fair market value of the security the day it is received by the charity and is not your cost. You benefit by avoiding the capital gain tax due at the sale of the security and giving the tax-laden security to the charity. If you like the investment, you can purchase the same security back and establish a new, higher cost basis. If you are over 70 1/2 and taking required distributions from your IRA, there is an opportunity to reduce tax liability here as well. The IRA charitable rollover will allow individuals over 70 1/2 to make tax-free charitable donations up to $100,000 from their IRA accounts. In past years, parents and grandparents may have considered gifting appreciated assets to children and grandchildren to take advantage of the potentially lower capital gains rates when these assets are sold (note that the donor’s cost basis is transferred with the stock). Those who may be in the two lowest brackets—10% to 15%— and subject to the 0% capital gains rate in 2017 may be appropriate recipients. Children subject to the “kiddie tax” ($1,050), who may pay tax at their parents’ highest marginal rate in future years, may be less appropriate recipients.
We expect more clarity on these important issues in the coming weeks. At this point in the year, it is unlikely that any changes in tax law will be retroactive for 2017. Our hope is that we can see agreement and unified effort in Washington, D.C. to put a more favorable tax plan in place for 2018. Our team will remain proactive in conveying information to you as more details emerge.
In the meantime, we hope these considerations shed some light on how proposed changes to the current tax structure may impact your financial plan. Please feel welcome to email sariangroup@hightoweradvisors.com with any questions on the points discussed here and their relevance to your situation.
HighTower Advisors do not provide tax or legal advice. This material was not intended or written to be used or presented to any entity as tax advice or tax information. Tax laws vary based on the client’s individual circumstances and can change at any time without notice. Clients are urged to consult their tax or legal advisor before establishing a retirement plan.