By Curt Overway
The Trump administration recently released its framework for tax reform, which included some specific proposals but left a lot of open questions for Congress to sort out. What does this mean for investors’ portfolios? At this point it is hard to say precisely but a few observations can be made.
We’ll focus here on the changes to the individual tax code. The changes to the tax rules applying to businesses may well have an impact on the general economy and the performance of the underlying investments in portfolios, but those effects will be difficult to predict with any degree of accuracy.
First, it is important to point out that this is an initial proposal. While there has been an effort to make this process somewhat more inclusive than other recent failed legislative efforts, this proposal, in its current form, faces some significant hurdles. There has already been strong pushback on the elimination of the state and local tax deduction, which is going to make it even harder to put together a package with a palatable impact on the deficit. Much of the hard work has been left to Congress to hash out, so there remains a lot of uncertainty about what any tax reform package might ultimately look like and whether it can get through Congress.
One of the key features of the proposal is the collapsing of seven tax brackets into just three with rates of 12 percent, 25 percent and 35 percent. This would lower the tax rate for top income earners from the current rate of 39.6 percent to 35 percent, though the framework does provide for the option to add a fourth bracket for high income earners if necessary. If this change goes into effect, investors in the top bracket would see taxes on short-term capital gains, interest income and non-qualified dividends drop slightly. There was no specific mention of capital gains or qualified dividend tax rates in the initial framework, so at this point we are assuming those will not change, though they could. With the reduced 35 percent tax rate, there would be a very modest impact on most investment portfolios.
Index-oriented equity portfolios, where the vast majority of the taxable events occurring tend to be long-term capital gains and qualified dividends, wouldn’t see much change on the after-tax returns realized by investors.
Actively managed equity portfolios typically have higher levels of turnover which is more likely to create at least some short-term capital gains within those types of portfolios. As a result, one might expect to see a bit more of a positive impact for investors in terms of slightly reduced tax drag on these investments. Analysis we’ve conducted, however, applying the new rates retroactively to broadly diversified, actively managed equity portfolios over recent history, suggests this impact will likely be minimal. Our analysis found that applying the lower tax rate of 35 percent instead of 39.6 percent for the ordinary income rate had virtually no impact on the after-tax returns of these portfolios.
The muted impact of these changes to the tax code on after-tax investment returns is due to the fact that (1) the changes to rates are relatively modest and (2) much of the returns in equity portfolios are generated through (primarily long-term) capital appreciation and qualified dividend income. At this point there is no discussion about changes to the capital gains or qualified dividend tax rates, so these components of return aren’t really impacted.
Investments that generate more of their return through interest income, such as taxable bond portfolios, could have a larger portion of the return subject to lower rates, but with interest rates at very low levels, that effect is likely going to be minimal as well.
The framework also eliminates most deductions, leaving just mortgage interest and charitable contributions. Currently, some investors may be able to deduct certain investment management fees if they itemize deductions. The ability to do this would go away under the proposed framework. This is unlikely to have a big impact for most investors as these fees could only be deducted to the extent that those deductions, along with other miscellaneous deductions, exceeded 2 percent of adjusted gross income. For now, the framework provides for retirement savings to remain tax deferred, but this is one issue still on the table.
Under the proposed framework the deduction of state and local taxes would also no longer be allowed. This could mean that the effective marginal tax rates for certain taxpayers in states with high tax rates could end up increasing.
The bottom line? Tax rates are still going to be at levels that create a meaningful drag on investment returns. Academic studies that have examined this have found the impact to be in the neighborhood of 1 percent to 2 percent, often greater than the impact of fees. While there is the potential for this tax drag to decrease slightly, it’s not likely to have a material effect. It will still be important for investors and their financial advisors to think about the tax implications of their investment decisions, and there will still be a substantial benefit to employing investment strategies and techniques that can help mitigate tax liability.
This continues to be an area that hasn’t been adequately addressed by many financial advisors but one that clients are very interested in. In our 2017 Global Investor Survey, we found that in the U.S. 41 percent of respondents indicated they needed professional help with tax planning. Nearly a quarter (21 percent) said that access to tax-efficient investments was a key factor in choosing a financial advisor. A substantial number (25 percent), however, admitted they don’t consider the tax implications of their investment decisions. These responses suggest that a good proportion of investors are looking for professionals that can help them navigate the joint complexities of their investment and tax situation, but that another significant segment is in need of education about how taxes can impact their realized investment returns.
Curt Overway is the President of Active Index Advisors and Managed Portfolio Advisors.