2017 Tax Reform Bill: Observations, Planning Ideas and Market Impact Commentary

Published:

Authors:
Howard Essner, JD, Managing Director, Family Wealth Advisor
John Micklitsch, CFA CAIA, President & Chief Investment Officer


Tax reform now appears to be a certainty and the details of the final bill have been released. Because virtually every major news outlet, including the Wall Street Journal, the New York Times, CNN and others have detailed coverage of the proposed law, we thought we would only summarize the key provisions of the bill, discuss the potential impact of a few of these changes, and suggest a few general planning opportunities for the rest of 2017.

Tax Reform Bill Observations

Key Individual Tax Changes

Note: most of the changes for individuals will expire in 2025 and revert to the current system.

  • Changes in tax rates: The proposal keeps the current 7 tax brackets, but generally lowers the rates and/or increases the amount of income subject to the rates. The biggest decrease comes at the top, where the highest marginal rate will drop from 39.6% to 37%. The 7 new tax rates are 10%, 12%, 22%, 24%, 32%, 35% and 37%.
  • Increase in the Standard Deduction: The standard deductions will increase to $12,000 (single) and $24,000 (joint), from $6,500 and $13,000. At the same time, the personal exemption (currently $4,150 for the taxpayer and all dependents) will be eliminated. The increase in the standard deduction will benefit many lower income taxpayers who do not currently itemize. It may also mean that fewer taxpayers will itemize, potentially impacting home ownership decisions and charitable giving. Also, the elimination of the personal exemption may negatively impact larger families, although this impact would be mitigated for lower income large families because of the increased child tax credit.
  • Increase in Child Tax Credit: The child tax credit will be increased to $2,000, of which $1,400 is refundable (i.e., payable as a refund even if no income tax is owed).
  • Education Benefits: The bill does not change favorable tax treatment for certain education expenses, such as student loan interest, tuition reimbursement plans, and teacher out-of-pocket expenses. 529 Plan assets, previously available for only secondary education, will be available to pay tuition and related costs for primary education.
  • Itemized Deductions: The bill makes several changes to itemized deductions:
    • The deduction for state and local income and property taxes will be limited to $10,000 per year.
    • The deduction on mortgage interest will be limited to the first $750,000 of debt, down from $1,000,000. This change will apply only to new mortgages.
    • Miscellaneous deductions, such as tax preparation fees, investment advisory fees, IRA fees, unreimbursed employee expenses, etc., will no longer be deductible.?
    • Job-related moving expenses will no longer be deductible (and employer reimbursement will be taxable).
    • The deduction of medical expenses will be expanded by reducing the floor to 7.5% of income (from 10% of income). This change applies only to 2017 and 2018.
  • Alternative Minimum Tax: The AMT has not been repealed, but the income thresholds for when it applies have been increased, thereby reducing the number of taxpayers affected by it.
  • Estate Tax: The exemption from the estate tax will double from $5.6 Million per person to $11.2 Million. The step-up in basis at death will remain intact.
  • Pass-through Entities: Certain owners of pass-through business entities (S-Corps, LLCs, partnerships), will be able to deduct 20% of the pass-through income, although the deduction will start to phase out at $315,000 of joint income. The implication of this change for business owners will be far-reaching and may present many planning opportunities in 2018 (and many unintended consequences).

Some Individual Planning Ideas

What, if anything, can be done in 2017 in anticipation of these rules? With tax rates likely going down and deductions being eliminated in 2018, the standard advice of accelerating deductions into 2017 and deferring income into 2018 seems more pertinent than ever. This approach may be especially important for state and local income taxes, since the deduction for these items will be limited to $10,000 in 2018. Here are some thoughts:

  • You should consider paying any final state and local income tax estimated payments for 2017, typically due in January, by December 31.
  • What about prepaying your 2018 state and local income taxes? Apart from the AMT concerns mentioned below, the proposed bill contains a provision clarifying prior authority that a prepayment of future year income tax is not currently deductible, so this idea (despite some web advice to the contrary) will not work.
  • You could consider prepaying the property taxes due in 2018. These taxes are really for 2017, so concern about prepaying income taxes does not really apply (and the provision in the bill mentioned above applies only to income taxes).

Of course, these are all just general guidelines. There may be many reasons why you should not follow them. For example, if you are subject to AMT in 2017 (or some other provision that restricts your ability to itemize deductions), then accelerating tax payments will provide no benefit. So before making any decision to prepay taxes, it is important that you and your tax preparer “run the numbers” to give you a clear understanding of the benefit and costs of doing so.

Some Market Impact Comments

The prospect for meaningful tax reform has undoubtedly been a tailwind for equity investors throughout 2017. More money in the pockets of consumers and lower corporate tax rates are generally positive for the economy and therefore for equity markets. This round of tax cuts appears as though it will be no different directionally although the size of the impact and the unintended consequences are always up for debate.

Tax Reform: Impact on Market Valuation

In terms of the size of the impact, the reduction in the corporate tax rate from 35% to 21% will have a positive, although more muted impact on public company earnings than perhaps investors are thinking. This is because the effective tax rate of the S&P 500 index is actually already well below 35% due to the blending of lower international tax rates from big, multi-national firms doing business all around the world. In fact, according to CNBC, the earnings multiple on 2018 estimated earnings for the S&P 500 would drop from 18.9x without tax cuts to 17.6-18.2x with tax cuts. So, not exactly a complete reset on the valuation debate. This is perhaps one reason small cap companies may see more of a direct benefit from tax reform because typically, more of their profits are earned within the United States, where taxes are highest. This tends to result in a higher starting effective tax rate for small caps than their large capitalization peers, meaning small caps could benefit more directly from the rate cut. Nevertheless, the lowering of the corporate tax should be a net positive for equity investors in terms of valuation, sentiment and the competitiveness of American businesses now that the tax playing field appears to be more level.

Tax Reform: Unintended Consequences

The biggest potential unintended consequence of tax reform, in our opinion, could be an unexpected pickup in inflation and perhaps an acceleration of the rate tightening cycle by the FED. Critics of tax reform have said providing stimulus to an economy already operating at near full capacity is like throwing fuel on what has been a largely dormant inflationary picture. If inflation were to accelerate in response to tax reform, it would undoubtedly cause the FED to re-examine its pace of rate increases. If the FED, which controls the short end of the yield curve, accelerates their rate increases and yet the market believes choppier water for the economy lies ahead and continues to invest in the long end of the curve, you could see a further flattening and inversion potentially of the yield curve. Inflation and the slope of the yield curve, therefore are two items to watch closely, post the passage of tax reform.

Tax Reform: Market Summary

Overall, we view the 2017 Tax Reform bill positively in terms of growth of the economy and sentiment towards the stock market. Moreover, low absolute levels of interest rates, low volatility and synchronous global growth have combined in 2017 to unlock the market’s animal spirits. Against this backdrop, we believe equities remain attractive relative to bonds, but remind investors that bonds and increasingly, hedged strategies, both play an important diversifying role in portfolio construction and can help manage overall volatility should less favorable market conditions present themselves in 2018 or beyond.  

Please contact your Ancora relationship advisor if you would like more information on any of the subjects discussed in this update.

The mention of specific securities, the securities of foreign exchanges and investment strategies in this presentation should NOT be considered an offer to sell or a solicitation of an offer to purchase any specific securities or securities listed on a particular foreign exchange. All data contained in this document is based on information and estimates from sources believed to be reliable. Please consult an Ancora Investment Professional on how the purchase or sale of specific securities can be implemented to meet your particular investment objectives, goals and risk tolerances. Past performance of investment strategies discussed is no guarantee of future results or returns. Investment return and principal value will fluctuate so that an investment when redeemed or sold may be worth more or less than the original cost. Statistics, tables, graphs and other information included in this document have been compiled from various sources. Ancora Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information. An investment is deemed to be speculative in nature.

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