It’s been more than a year since Congress passed, and President Trump signed, the Tax Cuts and Jobs Act of 2017. In the time since, Trump met with North Korean leader Kim Jong-un, the US imposed $34 billion in tariffs on Chinese goods, the Democrats retook the House of Representatives, the equity markets had their worst week since the 2008 Global Financial Crisis, France won the World Cup, Saudi Arabia allowed women to drive, and Prince Harry married Meghan Markle.
All of which is to say that you could be forgiven if a tax law from 2017 hasn’t exactly been at top of your mind. But here’s the thing: Even though the bill became law in December 2017, most of its provisions didn’t apply to the 2017 tax year. Which means the 2018 tax year—the very taxes we’ll all be filing come April—will be the first time we’ll have to truly grapple with the new law. What might it mean for investors? And what’s the outlook for investment taxes in 2019?
What’s in the new tax law: a refresher
In short, there’s a lot that’s new, from the widely applicable (revised individual income brackets) to the fairly arcane (a tax cut for citrus growers). But for the purposes of this blog post, let’s focus on just four key provisions affecting investors.
Lower tax rates on income, interest, and short-term capital gains
For 2018 through 2025, the law lowers income tax rates for most individuals, with the top rate down to 37% from 39.6%. These are the rates that apply to interest income and realized short-term capital gains or losses. Adding in the 3.8% tax on investments from the Affordable Care Act (ACA), the highest federal bracket will be 40.8% instead of 43.4%. For investment portfolios set up as trusts or pass-through entities, the tax rates may be even lower. However, deductions for state and local taxes have been limited, so in some cases investors may see an increase in their effective tax rate.
What it means for you: For many investors, a lower tax rate will mean increased after-tax performance in their investment portfolios. However, reductions in tax rates are modest and not universal, continuing to make active tax management extremely valuable.
Source: Tax Policy Center, 2019
No change to long-term capital gain and dividend tax rates
The tax act retains the existing 0%, 15%, and 20% brackets on long-term capital gains and qualified dividends. With the 3.8% tax from the ACA, the highest bracket is 23.8%.
What it means for you: There’s still a large difference between the short-term gain rates and the long-term gain rates. A key strategy for tax management still applies: Investors should avoid short-term gains, realize short-term tax losses, and defer long-term gains as long as possible.
Source: Tax Policy Center, 2019
The estate tax exemption has doubled
The estate tax exemption doubles for those estates realized between 2018 and 2025, from just over $5 million to more than $11 million for an individual. The step-up in cost basis of the assets at death is preserved in the new law. Charitable deductions are still allowed for those that itemize (but note that the standard deduction has also doubled, so taxpayers will need to clear a taller hurdle to claim charitable deductions on their taxes).
What it means for you: Fewer taxpayers will need complicated tax planning for their estates. Investors can defer tax liability into the future, realize the tax liability at the long-term rate, give away the liability by selecting the optimal tax lots for charitable giving, or simply let the tax liability expire with the step-up in basis that occurs when the estate is realized.
Source: Internal Revenue Service, 2019
AMT is still alive, but it will apply to fewer taxpayers
The alternative minimum tax (AMT) now affects only those taxpayers at higher income levels. Also, while under the old law many taxpayers triggered AMT with deductions for state and local taxes and property taxes, new limitations on those deductions means AMT will be harder to trigger.
What it means for you: From an investor’s tax-management perspective, AMT has a negligible effect.
What could change for investors in tax year 2019?
As we discussed in a previous blog post, with a divided Congress the chances of any major tax legislation getting through either chamber appears slim. In the days leading up to the 2018 midterm elections, there was talk of a middle-class tax cut, an idea Democrats have also embraced more recently, but in this political climate it’s hard to see the two sides coming to agreement on exactly what that might look like.
There were also murmurs from the Trump administration in July 2018 of using an executive order to index capital gains to inflation, which would have been a huge boon for high-net-worth investors (but would have brought with it a host of other complex issues to resolve). That idea also went nowhere fast.
So from a tax perspective, will nothing change in 2019? It’s very likely. But as fans of Seinfeld will tell you, there’s something to be said for nothing. For example, as Congress was negotiating the new tax law late in 2017, one proposal was to require investors to use a first in, first out (FIFO) accounting methodology for tax lots when calculating capital gains taxes. This would have caused capital gains taxes to go up and led to more assets stuck in concentrated portfolios instead of being appropriately diversified. Fortunately for investors, FIFO was left out of the final bill.
The bottom line
The new tax law may not truly be new anymore. Nevertheless, it presents investors with new complexities and opportunities for managing their taxes. And since this is the first year many of its provisions take effect, having an expert help navigate the changing landscape is more critical than ever.
Potential Parametric solution
One of the primary drivers of tax efficiency in a tax-managed Custom Core® account comes from tax-loss harvesting. Parametric portfolio managers will sell a basket of securities at a loss and simultaneously replace it with a different basket of purchased securities. The trade results in net tax losses for the client, which can offset capital gains realized by other parts of the portfolio.
Rey Santodomingo, CFA, Managing Director of Investment Strategy
Rey is responsible for all aspects of Parametric’s tax-managed equity strategies. As one of the primary strategists for Custom Core®, he works closely with taxable clients and advisors to design, develop, and implement custom portfolio solutions. Prior to joining Parametric in 2008, Rey was a vice president in product management at MSCI Barra. He earned an MA in financial engineering from the University of California, Berkeley, and a BS in chemical engineering from the University of California, Santa Barbara. A CFA charterholder, Rey is a member of the CFA Society of Seattle and a prior board member of the CFA Society of Seattle. He has also served as an adjunct instructor at Seattle University's Albers School of Business and Economics.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.