By CRAIG HAWLEY
Although Washington politics have been anything but usual, and gridlock over many key issues is causing headaches on both sides of the aisle, the decisive passage of the Tax Reform and Jobs Act late last year is seen as the most dramatic tax reform package in nearly three decades. It’s important to understand these new regulations and take on taxes now to give clients the best chance for success in 2018 and beyond.
Think Reform — And Beyond
According to Jefferson National’s 2018 Advisor Authority study of more than 1,700 registered investment advisors, fee-based advisors and individual investors nationwide, roughly eight in 10 (79 percent) of RIAs and fee-based advisors said that the majority of their clients will benefit from these reforms. But only slightly more than half (56 percent) of investors agree.
Investors’ outlook on tax reform varies considerably based on their net worth. Although less than half (49 percent) of mass affluent investors (with investable assets of $100,000 to $500,000) expect to see any rewards, nearly three-fourths (74 percent) of ultra-high-net-worth investors (with investable assets of $5 million or more) are confident they will benefit.
These reforms are expected to simplify the tax code, and many will see benefits from it. Yet taxes continue to be the single biggest investment expense clients will face, especially high-net-worth clients. Taxes can still be as much as 40 percent or more of clients’ earnings every single year, when federal and state taxes are combined.
Under these new provisions, taxes will continue to impact portfolios, while everything from the state your clients call home to their stake in the American dream of homeownership could have a very different impact on their tax bill this year versus last year.
Proactive Strategies Clear Up Complexity
As the study shows, RIAs and fee-based advisors are taking action to clear up the complexity and develop proactive strategies to help clients at every income level and stage of life. A majority of taxpayers will be in a new and lower bracket. But for clients in the accumulation phase, especially the high earners, taxes remain a top concern — and one of their biggest investing expenses. Likewise, retirees will still benefit from tax-efficient investing strategies and tax-efficient withdrawal strategies to maximize income.
Start preparing clients with greater tax diversification, using a range of different taxable accounts and tax-deferred vehicles, to control not only how much clients pay in taxes but also when they pay those taxes. Lawmakers backed off a controversial proposal to lower the amount that investors can contribute to tax-deferred retirement accounts, and it still makes sense for most to defer where they can, to increase returns without increasing risk, so they can preserve and grow their wealth.
This means maxing out 401(k)s to take advantage of any employer match, leveraging traditional individual retirement accounts and Roth IRAs, and ensuring that clients over 50 make catch-up contributions. Keep in mind that the new provisions have eliminated allowances for the recharacterization of Roth conversions, which had allowed investors to undo part or all of that conversion and remove the related tax bill.
For tax-inefficient assets that generate ordinary income and short-term gains — such as fixed-income, commodities, real estate investment trusts, liquid alts and actively traded strategies — use “asset location” in a tax-deferred qualified plan or a low-cost investment-only variable annuity to preserve all of the upside without the drag of taxes.
Then as you begin to plan for changes to your clients’ 2018 tax returns, consider the following:
Form 1040, Line 40: Standard Deduction And Personal Exemption
A wide range of taxpayers will likely be impacted by an increase in the standard deduction, along with elimination of the personal exemption and many itemized deductions. For single filers, the standard deduction for individuals rises from $6,350 to $12,000; for married couples filing jointly, the standard deduction increases from $12,700 to $24,000. Congress also retained the additional standard deduction for those over 65, including $1,600 for individuals and $1,300 for each partner of a married couple, providing an additional boost for many retirees. But at the same time, the personal exemption of $4,050 per person has been eliminated entirely.
Schedule A: Itemized Deductions
Itemized deductions allowed taxpayers, if qualified, to reduce their taxable income. According to IRS data, roughly 30 percent of taxpayers have been itemizing deductions in recent years. But this could decline to less than 10 percent as millions more are likely to take the standard deduction instead. As a result, more advisors will use timing strategies — grouping deductions together to maximize the benefit of itemizing in certain years, taking the standard deductions in other years.
Of the many changes, the elimination of tax preparation fees and investment advisory fees is important to note. The itemized deduction for investment advice that costs more than 2 percent of adjusted gross income is no longer available to clients under the new provision. This is a topic you may want to address with your clients to ensure that they continue to understand the value of holistic unbiased advice. Meanwhile, changes to the deduction of mortgage interest and state and local taxes may have the biggest impact on many of your clients.
Schedule A, Lines 10–11: Mortgage Interest
Historically, the cost of owning a home was made more affordable by the deductibility of mortgage interest and real estate taxes. Now, for any mortgage incurred after Dec. 15, 2017, the interest deduction on a qualified residence will be limited to $750,000 ($375,000 for married filing separately) — reduced from $1 million ($500,000 for married filing separately). Interest is still deductible for a second home; however, the $750,000 limit is applied to the first and second home in the aggregate. Also note that interest paid on home equity loans will no longer be deductible unless proceeds are used for specific purposes such as to buy, build or improve a main home or second home.
Schedule A, Lines 5–6: State and Local Taxes
Many consider this to be one of the most controversial provisions in the new tax law. Some have gone so far as to suggest that the loss of the SALT deduction will drive wealthy clients out of high-tax states such as California and New York. The aggregate amount of all state and local property, income and sales taxes that are deductible per year will be $10,000 (individual or married filing jointly) and $5,000 (married filing separately). Previously, this deduction was not subject to limitation.
Form 1040, Line 45: Alternative Minimum Tax
Although it was originally intended for high-income households, the AMT began to affect an increasing number of taxpayers in recent years. However, exemption amounts and the phase-out thresholds are now increased under the new reforms, making it less likely for the AMT to be triggered. The exemption amount increases to $109,400, up from $86,200 for joint filers. It increases to $70,300, up from $55,400 for single filers and $43,100 for married filing separate. The phase-out thresholds are increased to $1 million, up from $164,100 for joint filers, and increased to $500,000 up from $123,100 for single filers and $82,020 for married filing separately.
Form 1040, Line 52: Child Tax Credit
A positive change for most clients with dependent children is the increase in the child tax credit and the income levels at which it applies. Although the loss of the personal exemption will impact families with children, the new child tax credit may help alleviate the loss.
Under the new tax law, the child tax credit is doubled from $1,000 to $2,000 for each child under the age of 17 claimed as a dependent. The credit will phase out for high earners, but this now begins at $400,000 (joint filers) under the new reforms versus $100,000 (joint filers) last year.
Form 1099-Q: 529 Plans
The new tax law expands the use of 529 plans to now cover the cost of elementary and secondary education, including public, private and religious school expenses. Up to $10,000 per year per student can be distributed tax-free and penalty-free. Previously, 529 plan assets could only be withdrawn tax- and penalty-free for qualifying college expenses.
Schedule D: Investment Income
Tax rates for long-term capital gains and qualified dividends do not change and continue to use prior income thresholds. As a result, they no longer line up with a client’s ordinary income bracket. Short-term capital gains are still considered ordinary income and now follow the new ordinary income tax brackets.
The 3.8 percent surtax on investment income to fund the Affordable Care Act remains unchanged. Ultimately, you should continue to help clients structure tax-efficient portfolios, remain sensitive to taxes during rebalancing and use asset location with tax-deferred vehicles.
Form 706: Estate and Gift Tax
One significant change for high-net-worth clients is that new reforms essentially double the amounts that can be transferred free of the federal estate and gift tax and the generation-skipping transfer tax. The exemption amount increases to $11.2 million per person and $22.4 million per couple, up from $5.49 million per person and $10.98 million per couple. The annual gift exclusion amount also increases to $15,000 per gift per recipient, while the basis step-up rules remain unchanged.
The higher exemption will provide a greater opportunity to increase basis in inherited property. As a result, clients may want to gift cash or high-basis property during their lifetime, while low-basis property may be better suited for transfer at death so that it receives a step-up in basis. Other beneficial techniques include the use of irrevocable trusts, family limited partnerships and grantor-retained annuity trusts.
Take On Taxes Now
Year-over-year, taxes continue to be top of mind for investors. When asked what macro issue would most adversely impact their portfolio over the next 12 months, investors this year rated taxes No. 1, tying with global instability. When asked to identify their biggest financial concern over the next 12 months, investors rated taxes second, tied with protecting assets.
You can differentiate your firm and create more value for your clients by demonstrating your expertise in tax planning. In fact, six in 10 RIAs and fee-based advisors said that tax reform will provide them with the opportunity to expand their services and generate more business related to tax planning. Take on taxes now to ensure success in 2018 for your clients — and your practice.
Craig Hawley is head of Nationwide Advisory Solutions, formerly known as Jefferson National. Craig may be contacted at firstname.lastname@example.org.