How might the recent U.S. tax bill impact individual investors?

U.S. tax form With the House of Representatives and Senate passage of the bill formerly called the Tax Cuts and Jobs Act (TCJA), taxes are front of mind for many investors. It will take years to fully determine who the net winners and losers from the bill will be. For those investors (and advisors) who can’t afford to wait for years, here’s a quick summary of what’s likely to change and what isn’t if the TCJA goes into effect for the tax year 2018. First, let’s look at what the tax proposal is generally NOT changing
  • Capital Gains
    • Retain long-term capital gains (LTCG) rates of 0%, 15% and 20%
    • Under current law, the 20% rate applies to the top bracket of 39.6%. The new law breaks with this practice. As written, the top 20% LTCG rate applies to the existing thresholds as they exist today.
      • Current law: Married Filing Joint (MFJ) status, the LTCG tax rate of 20% applies to taxpayers in the top tax bracket with taxable income above $480,000.
      • New tax legislation: The top taxable income threshold (MFJ) increases to $600,000 (up from $480,000), but the 20% LTCG retains the $480,000 threshold.
      • A couple with MFJ status would pay the LTCG rate of 20% with taxable income above $480,000, but not cross the top marginal tax rate of 37% until taxable income crosses $600,000.
    • No change to definition of holding period for determination of Long-Term vs. Short-Term capital gains (STCG)
    • Short-Term Capital Gains (STCG) will continue be taxed as ordinary income (highest marginal rate for taxpayer). This includes items like interest income, non-qualified income and capital gains held for less than one year.
  • Net Investment Income Tax
    • The 3.8% Net Investment Income Tax on unearned income that exceeds a specific level lives to see another day. This tax has sometimes also been referred to as the “Affordable Care Tax.” For couples with MFJ tax status, the tax applies to Modified Adjusted Gross Income above $250,000 (not indexed for inflation).
    • As a result, this makes the top rate for LTCG 23.8% and STCG 40.8%.
  • Municipal Bond Interest
    • Interest from municipal bonds retains its tax-free treatment for most investors.
    • Private Activity Bonds (PABs)—typically issued by not-for-profit hospitals, universities, charter schools—retain their tax-exempt status.
  • Cost-basis rules
    • The Senate version of the bill considered forcing investors selling securities to treat all sales on a FIFO basis (First In First Out) instead of permitting specific lot identification. This could have increased many investors’ tax bills. In the latest version of the bill, this provision was eliminated, thereby preserving the flexibility for investors to identify those stocks with a higher cost basis, as appropriate for their tax-aware investment strategies.

Planned Changes:

  • New Tax Brackets and Rates for individuals Married Filed Joint (MFJ) for 2018 Tax (To be paid in 2019)
New tax bracket for married filed joint for 2018 tax Sources: Internal Revenue Service (current); Conference Committee (proposed)
  • Impact of inflation on tax-brackets
    • The IRS adjusts the thresholds for taxable income every year based on the level of inflation. Historically, the inflation assessment has been indexed to the Consumer Price Inflation (CPI). The tax legislation proposes to switch the adjustment to Chained CPI—which generally reflects a lower level of inflation. As inflation rises over time, more taxpayers are likely to be subject to the higher tax brackets than if the CPI was still the inflation index.
  • Alternative Minimum Tax (AMT)
    • The AMT remains intact for individual taxpayers
    • The exemption and phase amounts have gone up quite a bit, so consulting a tax advisor to thoroughly understand potential impacts on individual cases can be helpful.
  • Increased Standard Deduction
    • For MFJ taxpayers, the standard deduction goes from $12,700 to $24,000. Note that this is coupled with the elimination of personal exemption amount. Depending on the number of exemptions within a tax return, the amount of dollar change (+/-) will depend on the number of exemptions. By increasing the standard deduction, the tax legislation aims to have fewer taxpayers itemize and complete the required Schedule A.
  • Deductions for Personal Exemptions
    • Generally eliminated, as referenced above.
  • Deductibility of Mortgage Interest (both primary and secondary homes)
    • For those taxpayers who itemize, interest expense on loans up to $750,000 are deductible. This is a reduction from $1,000,000 maximum loan amount allowable today.
    • Mortgage loans finalized before the tax legislation go into effect will be grandfathered at the $1,000,000 threshold.
  • Property Taxes
    • Taxpayers may deduct only up to $10,000 total, which includes any combination of state and local taxes, including property taxes (also sales taxes).
    • For taxpayers in high tax states, this could cause an increase in total tax owed.
  • 529 Plans
    • The tax legislation allows for the proceeds from 529 plans to be used for K-12 and post-secondary education, making this vehicle more flexible
  • Estate Tax
    • The tax exemption for estates goes from $5.6 million per individual to $11.2 million.
  • Pass-Through Businesses
    • Multiple changes affect the income recognized through partnerships, S-Corporations and more that “pass-through” the business and are paid on the individual’s tax return. Depending on the character and amount of the pass-through income, it may qualify for a reduced tax rate. This provision will likely keep tax accountants and tax attorneys fully employed for years to come.
  • Taxation of Trusts
    • Trusts will continue to hit the top marginal tax bracket on taxable income above $12,700 in 2018—a much lower bracket than individual investors face.

The bottom line

The recent tax legislation represents the biggest change in the U.S. tax code since 1986 and will likely impact all taxpayers in some way. While it is too soon to predict the potential intended and unintended impact on the U.S. economy overall, the following is clear:
  • Tax bills may go down for many tax payers, but rates will not drop to 0%.
  • Tax-aware investing should still be a consideration for helping taxable investors reach their long-term financial goals.
  • For instance, focusing on long-term capital gains vs. short-term capital gains, and deferring capital gain recognition as appropriate are likely to remain powerful considerations for helping investments grow. Similarly, municipal bonds will likely continue to make sense for many taxable investors.
With taxes in the headlines daily, many investors are primed for a conversation about taxes. Don’t miss the opportunity to articulate for your clients and prospects how you can help them invest in a tax-aware manner—and the potential long-term benefits of considering such conversions now. This sort of conversation can help you not only differentiate yourself from other advisors but can also help uncover hidden assets.