The White House and Congress have recently outlined key components of their proposal on tax reform. The last time Congress passed major tax reform was in 1986 under Ronald Reagan. The bill that eventually passed had a clever name: Tax Reform Act of 1986.
Fast forward, nothing about our taxes are simple and we pay a lot of them – Federal, State, Local, Property, Medicare, Capital Gains, Estate, Corporate, Sales, AMT, Inheritance, Duty, Gift, Excise, Payroll, Cigarette, Gas, Self-Employed, Tanning (LOL!), and that tax that is on your wireless bill.
Below is a bullet point outline of what we know so far regarding the proposed changes in the tax code:
- Corporate tax rates to be cut to 20% from 35%
- Seven income brackets will be reduced to three
- Elimination of the Estate Tax
- Immediate expensing on capital investments, sunsets in five years
- Cuts the “pass-through” tax for small businesses to 25% from 39.6%
- Top tax rate for the wealthiest Americans to fall to 35% from 39.6%
- Doubling of the standard deduction
- Eliminating the deduction for state and local taxes
It is too early to tell what will ultimately pass but we wanted to share with you a few items that would have a direct impact on long-term plans.
Cut the top tax rate for small businesses to 25% from 39.6%
Companies that have a pass-through business will see their tax rate go from 39.6% to 25%. However, Treasury Secretary Mnuchin has said on the record that this reduction will not be for service related businesses – think of accountants, lawyers, consultants, and doctors.
Three Income Brackets
The proposed income brackets are 12%, 25%, and 35%. Because we have a progressive tax system, the income thresholds are an important detail but have yet to be disclosed by the administration.
Elimination of the Estate Tax
The Federal Estate Tax would be eliminated for estates over the current exemption of $5.5 million ($11 million if you are married). Above the exemption, estates must pay the government 40% of the fair market value of all assets and property within 9 months of the date of death. There are no estate taxes due when you leave money to your spouse, only when you transfer assets to the next generation.
For Individuals who DO NOT itemize deductions
Individuals who don’t own a business or have significant tax deductions could benefit from the “doubling of the standard deduction”. In 2017, the standard deduction is $6,350 for single and $12,700 for married filing jointly. The proposed standard deduction will jump to $12,000 for a single person and $24,000 for a married couple. The change will make it easier for households to do their taxes because people will opt to take the larger standard deduction rather than itemizing their deductions. The personal exemptions will go away which is $4,050. This could hurt a family of four. Under the current code, a family of four can get the $12,700 deduction plus 4 personal exemptions which amount to $18,000. The plan does keep the Child Tax Credit but the amount has yet to be disclosed.
For Individuals who DO itemize deductions
The elimination of the deduction for state and local taxes (SALT) will have a significant impact on individuals who live in high tax states with high incomes and itemize their deductions. States like – New Jersey, Connecticut, California, and Massachusetts see a lot of tax returns that claim the SALT deduction. Retirees are already leaving states with high-income tax rates and this I believe will hurt the states in the long run. Without that deduction, many might end up paying more in taxes under the GOP plan.
Taxes paid on capital gains
Capital gains are profits from the sale of assets that are taxed at a lower rate than ordinary income. Buying low and selling high is a smart strategy to follow but when you sell in a non-retirement the government claims a percentage of the profits. The government gets some of the upsides with no risk to the downside. The 3.8% surtax on net investment income above certain thresholds, $200,000 for singles and $250,000 for married couples will likely stay in place because this is tied to health care reform and we all know what happened with that. An interest question is whether net realized losses can be claimed as a tax deduction. Current tax law allows for realized losses up to $3,000 to be taken as a tax deduction. As stated above, certain deductions are going away and this could be one of them.
Effects on Asset Classes
US Stocks. Though the US markets are at all-time high, I believe the market would welcome any good news out of Washington. The market is expecting some sort of Tax Reform; however, when buying stocks, one must determine if the expectations are already baked into the price. All else equal, a lower corporate tax rate means more net income in the hands of the company. In turn, these companies can either increase their dividends or start paying a dividend, reinvest net income back in the company, and/or buyback company shares.
Municipal Bonds. When Trump was elected in November, interest rates spiked and intermediate and long-term bonds fell in value. Municipals declined more in value than comparable corporate bonds. The reason behind the larger sell-off was attributable to the assumption of lower tax rates which make municipals less attractive to taxable bonds. We still think municipals are an important tool for mid to high-income earners and will continue to be in demand as ordinary income tax rates won’t be changing too much. At this point, it is still unclear what the income brackets will look like.