After much speculation, Congress did pass its new tax law late last year. Many of the provisions went into effect last week. We have been analyzing the potential impact on investors and here’s what we think will matter the most for actively managing a portfolio to reduce the impact of taxes.
1. Lower tax rates on income, interest, and short-term capital gains
For 2018 through 2025, the new 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 that are 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 a very valuable activity.
2. No forced FIFO provision
The U.S. Senate version of the tax bill would have required the use of a first in, first out (FIFO) accounting method. This provision was discarded during the reconciliation process.
What it means for you: Investors still have the flexibility to select individual tax lots during transitions, when gifting securities, and when tax-loss harvesting.
3. No change on long-term capital gain and dividend tax rates
The new law 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 is 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.
4. Estate tax exemption doubled
The estate-tax exemption will double for those estates realized between 2018 and 2025, from $5 million to $10 million for an individual. The step up in the cost basis of the assets at death is preserved in the new law. Charitable deductions are still allowed for those that itemize.
What it means for you: Fewer taxpayers will need complicated tax planning for their estates. Our strategy allows investors to defer tax liability into the future. In the end, the investor can choose to 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.
5. AMT still alive, but will apply to fewer taxpayers
The alternative minimum tax (AMT) is still alive under the new law, but it will apply at much higher income levels starting next year. Also, under the old law many taxpayers triggered AMT with deductions for state and local taxes and property taxes. With higher thresholds and new limitations on these deductions in place, AMT will be harder to trigger.
What it means for you: From an investor’s tax-management perspective, AMT has a negligible impact.
We think the new tax law presents investors with new complexities and opportunities for managing taxes. Having an expert help navigate the changing landscape is more critical than ever.
The Value of Tax Alpha
Parametric’s Custom Core strategies are designed to provide flexible, tax-efficient equity index exposure. “Tax alpha” is how we quantify the value of active tax-management. Here, we explore the two key drivers of tax alpha - the overall market return and cross-sectional stock volatility.
Our Custom CoreTM Strategies let investors take charge of their passive mandates. Since our portfolios are held as separate accounts, we can customize them to meet client needs. Investors can select from a wide range of benchmarks and then tailor their exposure to incorporate their unique objectives.
Paul Bouchey, CFA - Chief Investment Officer
Mr. Bouchey leads Parametric’s investment, research and strategy activities. His research interests include indexing, tax management, factors, and rebalancing. Paul earned a B.A. in mathematics and physics from Whitman College and an M.S. in Computational Finance and Risk Management from the University of Washington. He holds the Chartered Financial Analyst designation.
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.