What Does Tax Reform Mean To You and Your Portfolio?
Economy | Planning Perspectives | Portfolio Management
Congress and the President recently passed the biggest tax reform in over 30 years. The Tax Cuts and Jobs Act of 2017 aims to make the United States corporate tax rate more competitive and therefore increase corporate investment domestically. The bill also provides for individual tax breaks beginning in 2018, that will expire at the end of 2025.
What Does This Mean For My Portfolio?
Corporations will now be taxed on U.S. profits at 21% instead of 35%. Generally, this translates to a lower tax expense for corporations, which means higher earnings per share (EPS). A higher EPS would help support current stock market valuations or potentially allow for further market increases in future earnings seasons.
In addition to corporations getting a reduction of their income tax rate, there is also a rate reduction in the so-called repatriation of offshore money. Prior to this tax bill, corporations were previously incentivized to create offshore entities and filter profits abroad in order to pay fewer taxes. If they chose to bring this offshore cash back to the United States, corporations would be taxed at US corporate income tax rates which was 35%, but this could be partially offset by the taxes paid abroad.
With the new law, corporations will see a one-time rate reduction (aka a “Tax Holiday”) on these overseas profits. Currently, there is an estimated $1.9 trillion dollars of overseas cash from US based corporations.[1] What will the corporations do with this influx of cash? Well, a similar tax holiday took place in 2004 and this is what happened: for every $1 of foreign cash brought back, $0.92 of that $1 was spent on either dividend increases or share buyback.[2] What will happen this go-around? Based on recent quarterly statements by many American corporations, in some cases, at least 60% of the tax savings are going to shareholders in the form of buy-back programs and increase dividends.[3]
How will this affect the market in 2018? The tax savings and share buy-back expectation partially fueled the 19% return on the S&P 500 in 2017 [4] and the run may carry over to the 2018 calendar year. However, with stock valuations at historical highs, how much more run up can we expect? In a period of rising interest rates with stock valuations and corporate debt levels at historical highs, the potential for increased volatility and market downturns needs to be considered in the near-term.
What Does This Mean for My Taxes?
Like most of us, my initial thought when the bill was passed was “Am I going to save money?” The simple answer is: it depends. I know, but bear with me.
In terms of taxes and your portfolio, long-term capital gains rates did not change. Although, the income thresholds did change slightly. In general, your marginal tax rate (the rate at which your final dollars are taxed) went down. The exception being for middle to higher-class individuals making $200,000-$424,950 and married couples making $400,000-$424,950. On the other hand, depending on your tax bracket, your effective tax rate (your total tax liability divided by your total income) could potentially go up. How can that be? The answer is various deductions were either eliminated or the benefit was reduced.
For example, the personal exemption was eliminated, but the standard deduction nearly doubled. The fact the standard deduction increased sounds encouraging. But with the loss of the $4,050 personal exemption, the instant savings isn’t always the case. The net effect for individuals is an increased deduction of $1,600 and for a married couple without kids about $3,200. For married couples with children, due to the loss of the personal exemption for each family member, even with the increase in the child tax credit, the amount they could potentially deduct from their tax bill could possibly go down.
You can see how this starts to get complicated. For taxpayers who chose to itemize their deductions in the past, there are some additional significant changes that need to be mentioned. The state and local tax deduction is capped at $10,000. For Washington State residents, this doesn’t matter as much since the state has no income tax, but for individuals residing in high income states (i.e. California, New York, and New Jersey) this is much more important. Additionally, the mortgage interest deduction changed slightly. You can now take a deduction for interest deduction paid on $750,000 of debt versus $1,000,000 in 2017.
The Takeaway
The Tax Cuts and Jobs Act will affect the economic landscape going forward. Corporations now have more incentive to filter profits domestically and invest in the United States. Individual taxpayers will see some changes on their 2018 tax returns and may experience some tax savings, however these changes will expire in 2025. Long-term this has the potential to be a win for US corporations and US equity investors. However, the fact that the reduction in tax revenue has not been offset by any spending cuts, as of yet, means future economic uncertainty still remains.
Disclosure: The information contained in the blog post does not constitute tax advice and you should consult with a tax advisor about your own situation.
[1] https://www.moodys.com/research/Moodys-US-corporate-cash-pile-to-rise-5-to-19–PR_375739
[2] https://taxfoundation.org/repatriation-tax-holiday-hangover
[3] https://www.bloomberg.com/gadfly/articles/2018-03-05/five-charts-that-show-where-those-corporate-tax-savings-are-going
[4] http://performance.morningstar.com/Performance/index-c/performance-return.action?t=SPX