Listen to this article
Investors sharing Albert Einstein’s sentiment that US income tax was the world’s most complex topic found little relief in December’s US tax overhaul.
The most sweeping changes to the code in 30 years reduced federal income tax rates, doubled the estate tax threshold, and trimmed rates for legal structures common to small business — in addition to offering generous corporate tax cuts.
The new rules offered President Trump’s administration one of its few legislative victories so far but drew criticism over the expected increase in national debt, which the bipartisan Congressional Joint Committee on Taxation has pegged at about $1.5tn over the next decade.
The rushed nature of the bill also called into question whether — and how — lawmakers and tax experts would have been able to gauge its economic impact, with last-minute additions scrawled in the margins making it into the final 503-page bill.
For individual investors, the new code will have varying effects depending on a long list of factors. However, behind the complexity, several important tweaks require investors and their financial advisers to take stock of portfolios, according to experts in the field.
“From an individual perspective, there are so many provisions out there that some are positive changes and some are negative,” says Kristina Gretzschel, a tax and financial planning manager in Wells Fargo’s wealth management unit, which oversees $1.6tn of investments. “Some will have a lower tax liability but there will be others that may owe more tax, given their individual situation.”
One overarching reason tax cuts will not drive down everybody’s yearly bill is the addition of a $10,000 cap on deducting state and local taxes. This will hit high earners in states such as New York, New Jersey and California. In particular, residents of New York City, who pay income tax at the state and city level, will probably face limitations on how much can be deducted from federal income tax.
In addition, the size of mortgages eligible for interest deductions has slipped from $1m to $750,000, although this will only affect mortgages originating from 2018. Similarly, the new code tightens a previously broad category of loans against which taxpayers were able to deduct interest, known as home equity loans.
“If you used it for something other than to buy, build or improve your home — college expenses, buying a car or boat — that’s not considered home equity debt and starting in 2018 that is not deductible at all,” says Ms Gretzschel.
These changes should spur financial advisers to ensure clients are smart about which loans they use, says Tom Holly, a partner at PwC, where he advises wealth managers.
“A wealthy client could have borrowings for investing, principal residences, businesses — all of those lending structures need to be reconsidered or recalibrated as a result of this tax reform,” he says.
Another crucial change that wealth advisers will have to heed is the doubling of the estate tax threshold to $11.2m. This marks yet another significant change to the limit on tax-free transfer of property at death, which stood at just $1m in 2002.
Tax rules will in effect allow investors to double this tax-free allowance across a married couple’s estate to $22.4m, says Timothy Steffen, director of advanced planning for wealth manager Baird, which controls assets worth $171bn.
“The large estate tax exemption does eliminate tax problems for most people but it doesn’t alleviate the need for planning,” Mr Steffen says. His firm advises clients to work with tax-focused accountants and attorneys when finalising estate plans.
Investors may also be more open to education-focused investment vehicles known as “529 plans”, named after the associated section of the Internal Revenue Code. These were previously geared to distribute funds for college-related expenses, but can now be used for high school and pre-school costs — a move expected to broaden their appeal.
Certain asset classes have benefited from the tax changes, too, which could prompt tweaks to the mix of assets advisers might choose to recommend to their clients.
“The big winner in tax reform has been real estate,” says Mr Holly. Taxes on income and dividends earned through real estate investment trusts face steep reductions. This is because they are classified as “pass-through entities” and do not apply to direct real estate investments.
“You don’t make an investment purely for tax reasons, but the after-tax cash needs to be a consideration,” he says.
The comprehensive changes come with a caveat. Those targeted towards individuals will expire after 2025, while the business-focused tweaks have no expiry date.
Investors should keep their options open in case any specific changes disappear, Mr Steffen says.
To underscore the point, he offers a cautionary tale. At the end of 2012, the estate tax exemption threshold was set to fall from $5.12m to a previous $1m level.
However, a last-minute bill rushed through Congress on New Year’s Eve marginally increased the level, catching off-guard investors who had — it turned out — needlessly distributed assets.
“People who had given away assets thinking the exemption would fall from $5.12m to $1m were looking for ways to claw those dollars back into their own names,” Mr Steffen says. “I don’t know how many were successful in clawing those dollars back into the estate, but I know the estate attorneys were working hard to try and make it work.”
Among restrictive changes relevant to some investors is the scrapping of a 2 per cent investment expense deduction, which may reduce the use of certain vehicles popular among rich clients including the use of separately managed accounts.
In reassessing the value of these accounts, investors should pay close attention to the underlying aims of the investment strategy they are pursuing, says Ms Gretzschel.
Investors may also want to act more strategically regarding their philanthropy under the new tax law. Charity-focused investment vehicles, called donor-advised funds, now allow investors to deduct 60 per cent of contributions from their taxable income — that figure that was previously 50 per cent.
“For charity-minded clients that will be a good tool going forward to bunch deductions over a number of tax years so they can itemise and get the benefit of those charitable gifts,” says Mr Steffen.
One clear consequence of the tax code shift is its potential to increase the value of a financial adviser at a critical time for the wealth management industry.
As platforms automating investment advice — known colloquially as “robo-advisers” — increase their market share, the drastic changes to taxation are expected to enhance the value of a human adviser.
“The level of interest with tax reform was arguably like nothing I’d ever seen in 25 years of doing this,” says UBS financial adviser Jason Katz, who works as part of a team overseeing $2bn in client assets. “In one shape or form, we’re all affected. People’s livelihoods are at stake.”
Get alerts on US tax when a new story is published