“Don’t tax you, don’t tax me, tax that fellow behind the tree,” quipped Senator Russell Long, who chaired the powerful Senate Finance Committee from 1966 to 1981.
Tax Reform is Here
This past year, Halloween was barely over when House Republicans introduced their version of tax reform. Few observers thought such a massive undertaking could be signed into law within seven short weeks.
But that is exactly what happened. In the hectic days that preceded Christmas, the president signed into law the most sweeping change in the tax code since 1986.
The legislation will result in substantive tax reform for corporations, with the elimination of the corporate alternative minimum tax (AMT) and consolidation down to a single 21% tax rate (from 35%), all of which are permanent.
However, when it comes to individuals, the new legislation is more of a series of cuts and tweaks, which arguably introduce more tax planning complexity for many, and will be subject to another infamous sunset provision after 2025.
The often-stated goal of tax reform was simplification. But simplification means much lower tax brackets can only be achieved if cherished deductions and credits are done away with.
It’s easier said than done.
Where did my tax deductions go?
Sure, simplification is a lofty ideal, but, “don’t take my deductions or credits from me,” has always been the taxpayers’ battle cry. And yes, Congress heard and listened to some of those pleas.
While some deductions will disappear, others remain or have been reduced. Senator Long probably would have sported a grin when President Trump signed the massive bill.
Sharpen your pencils — the new tax code and tax planning
More than 80% of Americans will get a tax cut next year, while just 5% of taxpayers
are expected to pay more. In most cases, cuts are expected to be modest, but much will depend on individual circumstances.
Many experts are struggling with the details of the bill, and that’s to be expected this early in the game.
Let’s touch on the high points. This applies to tax year 2018.
- The 10% bracket remains unchanged, while the 15% bracket declines to 12%, the 25% to 22%, the 28% to 24%, the 33% to 32%, the 35% holds steady, and the 39.6% slips to 37%. The thresholds are modestly adjusted above the new 22% bracket.
- The standard deduction nearly doubles to $12,000 for single filers and $24,000 for married filers, reducing the incentive to itemize and simplifying for some taxpayers.
- The $4,150 personal exemption is eliminated, and the $1,000 child tax credit doubles to $2,000. In general, rules for charitable contributions remain unchanged. By itself, the combination of points one, two and three will provide modest tax relief for most families. However, it depends on your individual circumstances.
- Those in high-tax states could see the biggest hit, as there will be a $10,000 cap on state, local and property tax deductions.
- For investors, the preferential treatment for long-term capital gains and dividends remains intact, as is generally the case for retirement accounts. One important change — the new law repeals rules that allow for re-characterizations of Roth conversions back into traditional IRAs. Once you convert into a Roth, there’s no going back.
- The 3.8% Medicare surtax on investment income for high-income taxpayers was retained. The tax survived tax reform and is likely to remain a permanent feature of the tax code going forward.
- The AMT for individuals was not repealed, but exemptions have been widened.
According to the Tax Foundation, Congress passed the AMT in 1969 after the Secretary of the Treasury said 155 people with adjusted gross income above $200,000 had paid no federal income tax on their 1967 tax returns.
The AMT was never adjusted for inflation and grew into an onerous feature for many Americans. In inflation-adjusted terms, those 1967 incomes would be roughly $1.2 million in today’s dollars.
Ideally, it would have been eliminated from the tax code. While the AMT commonly affected those with around $150,000 to $600,000 of income, in the future, AMT exposure will be much smaller, and it will be extremely difficult to be affected at all, especially given more limited deductions.
- The estate tax survived, but the exemption will double from $5.6 million to $11.2 million, and $11.2 million to $22.4 million for couples.
- The new tax bill also repeals the Obamacare mandate that requires all individuals to obtain health insurance. It becomes effective in 2019.
It’s important to point out that many of the more popular changes in the tax code for individuals will sunset in 2025. While many may eventually be made permanent, as we saw with the Bush tax cuts of 2001 and 2003, there’s no guarantee this will happen again.
- And for businesses: Given that the 21% corporate tax rate applies only to C-corps, there will be a 20% deduction for pass-through entities, such as S-corps, partnerships and LLCs. This will be a welcome benefit for many business owners, but complex rules may limit the pass-through for some entities.
Final Thoughts On the New Tax Code
We fully expect that the rewrite of the tax code will produce unintended benefits and unexpected consequences.
From an economic standpoint, Congress and the president hope to unleash the “animal spirits” that have been lethargic for much of the economic expansion. They hope changes, especially as they relate to business, will encourage firms to open new plants, expand in the U.S. and level the playing field with the global community.
Prior to reform, the U.S. corporate rate was the third highest among 188 nations. The $64 million-dollar question — will it work? About 90% of economists surveyed by the Wall Street Journal expect a modest boost to growth in 2018 and 2019, but after that, opinions diverge.
If tax incentives boost productivity, it could lift long-run GDP potential, which would yield a significant benefit. If the economic benefits end after a two-year sugar high, it will likely be deemed a failure.
Early anecdotal data offers some encouragement, as several large firms announced year-end bonuses or wage hikes tied to the lower corporate tax rate.
At a minimum, the lower tax rate increases longer-run after-tax earnings, which played a big role in the late-year stock market rally. It could also boost corporate stock buybacks and dividends going forward, which would create an added tailwind for stocks.
That said, we are cautiously optimistic it will encourage entrepreneurship and economic growth, which would benefit hard-working Americans.
Looking Ahead to the Market in the New Year
Let’s use simple math to guide us as we enter 2018. The S&P 500 Index advanced 21.83% in 2017. That figure includes reinvested dividends. No question about it, 2017 offered rich rewards to those who invested in a well-diversified stock portfolio.
So, does a sharp upward advance in one year set the stage for a pullback in the following year? Not if we use the historical data as our guide. We recognize the following examples are a little heavy on numbers, but we believe you’ll find the evidenced-based approach to be quite enlightening.
Since 1950, the S&P 500 has risen at least 20% (including reinvested dividends)
24 times (excluding 2017). In the year that followed, the S&P 500 finished higher ( including reinvested dividends) 19 times. Put another way, the S&P 500 rose 79.2% in the year that followed a 20% or greater advance, with an average gain of 18.1%.
Since 1950, the S&P 500 (including reinvested dividends) has finished higher 79.1% of the time, excluding 2017. The average advance when the S&P 500 finished higher (looking only at years that finished positively) was 19.1%.
When the S&P 500 has declined following a 20%+ advance, the average drop has been 6.5%.
Based purely on the examples above, last year’s impressive advance has little predictive value, with one exception. It simply tells us that stocks have an inherent upward bias over the longer term. Upward bias is a key component embedded in your financial plan.
What will impact shares next year?
Longer term, it’s always about the fundamentals, i.e., economic growth and profit growth. Low inflation and low interest rates only sweetened the pot last year.
The momentum generated by a growing U.S. and global economy is likely to carry over into the new year. While a 2018 recession can’t definitively be ruled out, leading indicators suggest the odds are low.
That said, unexpected events can create short-term emotional responses in the market that are best avoided by long-term investors.
Last year’s lack of volatility was simply remarkable. According data from LPL Research and the St. Louis Federal Reserve, the biggest drop in the S&P 500 amounted to just 2.8%. It was the smallest decline since 1995.
The average intra-year pullback for the S&P 500: 13.6% (LPL Research).
It’s an excellent reminder that volatility is typically a part of the investment landscape. It can sometimes be unnerving, but it’s incorporated into the investment plan we’ve recommended for you.
Table 1: Key Index Returns
Source: Wall Street Journal, MSCI.com, MarketWatch, Morningstar
MTD returns: Nov. 30, 2017 – Dec. 29, 2017
YTD returns: Dec. 30, 2016 – Dec. 29, 2017
**In U.S. dollars
As 2018 gets underway, we want to wish you and your loved ones a happy and prosperous new year!
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