It would behoove advisors and their clients to pay attention to what’s going on in Washington, especially when it comes to tax reform and the impact of Congress’ dysfunction. That was the message of Andy Friedman, principal of The Washington Update, when he spoke to advisors at the Financial Services Institute’s annual Advisor Summit in Washington, D.C. this morning. The politics coming out of Washington can greatly impact clients’ portfolios, Friedman said.
Friedman told advisors to keep an eye out for “forcing events”—times when Congress has to act, such as the fiscal cliff debacle. Those are buying opportunities, he said. The next forcing event should come in March, when the debt ceiling has to go up. Congress probably won’t approve it right away.
“But come late spring or early summer next year, when markets drop because of concern that the debt ceiling’s not going to go up, that’s a buying opportunity,” Friedman said. “We’re dysfunctional here but we’re not so dysfunctional that we’re going to let the U.S. default on its debt.”
Tax reform is another area of politics to look out for, Friedman suggests. U.S. Rep. Dave Camp, head of the Ways and Means Committee in the House of Representatives, has put out a proposal for tax reform that would lower the top tax rate and add a 10 percent surcharge for families with over $400,000 in annual income. In addition, tax exempt interest on municipal bonds would now be subject to the 10 percent tax. Camp’s proposal also lowers the corporate tax, to try to limit corporate inversions.
“But what we say here in Washington is, ‘tax simplification is complicated stuff,’” Friedman said.
In other words, we probably won’t see tax reform next year, at least not individual tax reform. Democrats insist that tax reform brings in revenue, while Republicans insist it be revenue-neutral. Camp’s proposal is the latter.
Tax reform is also complicated because you have to make sure any reform does not unduly benefit the wealthy. And if you’re going to drop the top tax rate and not make any revenue, you have to make up that revenue by curtailing or eliminating a lot of the sacred deductions and exemptions that we’re used to, such as mortgage interest deductions or charitable contributions, Friedman said.
So we’re likely stuck with the top tax rates we currently have, and with impact of Obamacare and the fiscal cliff settlements, those taxes jumped 10 percentages points last year, Friedman said.
“So we want to be mindful of the tax drag on our clients’ investments.”
That means looking at things like harvesting losses, buy and hold strategies, municipal bonds, MLPs, and REITs—all the things that flow through income with low or no taxes. Friedman also recommends advisors take a close look at the mutual funds they use and whether they are tax-inefficient.
“Because if they’re tax inefficient, you could be losing half of the returns now with taxes,” he said.
Friedman suggests moving them instead into tax-deferred vehicles, like IRAs and variable annuities. The benefit of that deferral is going to much greater now that we’ve seen these tax rates.