What Tax Reform Means for Advisors and Clients

The other overlooked change was capping interest deductions for companies at 30% of adjusted income. Long term, this will lead to a delevering of corporations because the tax benefit of leverage is capped. This means less corporate investment grade and high-yield debt will be available. This also means lower yields because of limited supply, and investors will have to pay up for exposure.

Wolf: C Corps’ tax rates are down to 21% from 35% — that’s a 40% decrease and is incredibly dramatic. C corps still are not better if you want to pass out your income, or in other words, distribute income to owners. But if you want to keep income in the business because you want to grow the business, a C Corp might be a better vehicle for the first time in a long time.

Then there’s the loss of state income and property taxes as deductions. In high-tax states like California and New York, most people have state income and property taxes that are more than $10,000, so the deduction doesn’t go very far.

It’s a hot topic in Los Angeles, where I have a lot of clients who are very upset. They think their taxes will go up because they can’t deduct [all their] state income and property taxes anymore. But I tell them, ‘Wait a minute. Before we had the Alternative Minimum Tax, which basically wiped out a lot of benefits of state income/property tax deductions anyway.”

Your taxable income is important. If it’s between approximately $80,000 and $300,000, you’re subject to the AMT more so than other people. But the AMT no longer applies, because the main item that caused AMT was the state income tax deduction. So, the AMT is not a substantial factor anymore.

Who gets hit worse? Generally, people who make more than roughly $400,000 and have a lot of property and state income tax will be hurt with the limited deductibility of those items.

Of course, now there is the standard deduction of $24,000 (married/joint filing). Also, rates come down from a maximum of 39.6% to 37%. Still, on balance, if you make more than approximately $400,000 to $500,000 a year, you’ll likely have a net tax increase.

Astrinos: Because of the changes to tax law, a combination of new and old tax financial planning strategies will become more popular. As mentioned previously, because of the increases to the standard deduction, many households will no longer itemize deductions, which means that tax deductions that were once commonly used in full, such as state and local income taxes, property taxes, mortgage interest, and charitable deductions, may not be utilized.

It’s important to note that just because these deductions may not be utilized does not mean that the client is worse off; the impact on each client will vary. For example, some clients who were above the previous standard deduction but well below the current standard deduction may now benefit from an overall increase in total deductions, which will lower their overall tax liability.

On the other hand, clients who were above the previous standard deduction and still below, but very close to the current standard deduction, may no longer “get credit” for some of their deductions. As a result, we will begin to see a lot more timing strategies focused around grouping deductions together in order to maximize the benefit in any given year, meaning itemizing in some years and taking the standard deductions in others.

Tools such as the use of Donor Advised Funds where clients can control the timing and amount of charitable deduction will become more popular. In addition, previously used planning techniques such as Roth IRA conversions will resurface for those clients who are currently in low tax brackets, but expect to be in a higher one in the future.

What age group of clients will new tax law affect most (pre-retirees/retirees, etc.), and how should advisors optimize/minimize these changes for these clients?

Friedman: The law is likely to affect pre-retirees, that is, people whose annual earnings likely are at the peak. For these people, careful tax planning is necessary to balance the benefit of the slight reduction in tax rates with the new restrictions on, and lower utilization of, itemized deductions.

Investors who are employees presumably should continue to maximize their qualified (deductible) retirement plan contributions. But small business owners eligible for the new pass-through deduction might do better instead to eschew qualified contributions (which will offset income taxed at a lower rate) or to make such contributions to Roth accounts.

Hickey: This impacts all constituencies. For people in their wealth accumulation stages, this means that they might help reach their retirement goals faster. For retirees, this might mean additional wealth or buffer until savings are depleted. For business owners, this might mean transitioning day-to-day ownership to fully take advantage of the new passive rate.

Astrinos: It’s hard to generalize about how the new tax law will impact certain demographics of clients more than others. What I can say is that everyone will be affected, but the magnitude depends on their particular circumstances.

For example, if you are in the accumulation phase of the investment cycle, a high-income earner, and still have many deductions, you’re going to want to do ongoing tax planning to ensure that you’re maximizing deductions on a year-to-year basis. On the other hand, if you’re a retiree in the decumulation phase, low income, and don’t have many deductions, (i.e. maybe you don’t have a mortgage or you have very low property tax basis), then you’re still going to want to do ongoing tax planning to take advantage of opportunities to draw down from your portfolio in the most tax efficient manner and manage your investment portfolio in a way that produces the highest after-tax return. In either case, advisors will be trying to squeeze out every last dollar they can within the constraints, facts and circumstances of each client.

What do you see as long-term effects of this tax law on the economy, as well as on the wealth management business and advisors?

Friedman: Since President Trump first began touting the benefits of a major tax cut, I have been concerned that the resulting stimulus is coming at the wrong time. Adding over $1 trillion of stimulus to an economy so close to full employment runs the risk of rekindling inflation.

If the Fed begins to see signs of inflation, it might raise interest rates faster than it would otherwise. Higher interest rates — forcing businesses to pay more to borrow — would slow down the economy, counteracting the stimulus the tax cuts were intended to provide. I should add that reasonable people can and do disagree with this position, noting in particular that the reduction in tax rates was necessary to help U.S. companies compete globally.

Hickey: This will have a huge impact on the U.S. economy for years to come in terms of accelerating growth. Most publicly, we anticipate roughly $1 trillion being repatriated to the United States from overseas. Part of this will be investing by U.S. companies. In addition, lowering the effective corporate tax rate to 21% will likely mean companies will invest part of the saving into growth opportunities.

Beyond these growth opportunities, this should help drive global interest in investing in the United States. More capital for investment ultimately translates into economic and job growth.

For wealth management and investment management business, this is good news. This makes investing in U.S. equities a potentially more compelling option for the foreseeable future.

Wolf: A huge impact on business is the 100% bonus depreciation, which always has been an incentive to stimulate the economy and to have businesses invest more in capital improvements. But this now is bigger than ever.

Basically, you can write off all your capital expenditures whether you’re a billion-dollar company or a small company. There used to be a cap, but now every company can do this. It should stimulate economy and cause people to invest in capital improvements, because they can write them off and shelter their income.

That, in combination with the C-Corp tax rate being reduced to 21%, is something like a 40% reduction in income taxes, which is mind-boggling. If you’re a publicly traded company, you can write off all capital improvements, which will have a tremendous benefit and should stimulate the economy.

Also, changes in the deductibility of business interest should impact both private and public businesses. You cannot deduct this interest if it exceeds 30% of earnings before interest, taxes, depreciation and amortization (EBITDA).

This business interest deduction limitation probably means M&A transactions will be done differently, with more equity and less debt — which should have a big impact on M&As. All businesses will have to think twice about how much leverage they want, so it will be interesting. This change doesn’t apply to real estate, which can deduct more than 30% of EBITDA. Advisors will need to understand and see how this change impacts M&A activity for clients.

Astrinos: I’ll start off by saying that I’m not an economist, so I cannot predict what the impact of the new tax law will be on the economy. This isn’t the first time we’ve seen an administration enact changes to tax law.

What’s particularly interesting about this change is the surge of interest from the average client, even those who historically weren’t interested in money-related discussions like taxes, investments and the financial markets. It seems like a lot more people have now taken an interest in their own financial health, which I think is great for the consumer because they should play an active role in their finances.

Professionals also will be in the spotlight as there’s heightened awareness around finances and questions arise from consumers. They will need to ensure that they maintain a high standard of care and adapt to the changing needs of consumers.

This won’t be the last time that change affects clients and our industry, so clients and professionals should learn from this experience and put together some best practices to adapt now and into the future. Examples include regular communication, education/training opportunities for the client and professional, and leveraging technology whenever possible.

Overall, what advice would you give advisors in terms of most helping clients and/or working in cooperation with accountants/tax experts given all these reforms?

Friedman: The new tax law was not only sweeping — it was sudden. It serves as a reminder that taxes change, and often without much notice. And that trend will continue: At some point, the Democrats will be back in power and likely will raise tax rates.

Even if that does not happen, most of the changes in the new tax law expire by their terms in 2025, so advisors need to prepare their clients for “tax volatility.” This means having different investments and different accounts that allow a client to modulate taxable income, particularly in retirement, to account for different tax rates.

Advisors should make sure clients have different types of accounts — taxable, tax-deferred — and different types of investments — ordinary income, capital gains/dividends, tax free, tax deferred — so that they can recognize more taxable income when taxes are low and less taxable income when taxes are high.

Hickey: The fundamentals for investing stay the same. This just makes investing in U.S. markets more compelling. As a result, we have slightly tilted our portfolios for more U.S. small-cap and mid-cap exposure because we think these asset classes will outperform.

Investments in individual sectors may be more volatile than investments that diversify across many industry sectors and companies. Certain sectors of the market may expose an investor to more risk than others.

Wolf: Most advisors charge asset management fees of about 1% of assets. Now broker commissions are deductible as an adjustment on the gain of sale of an asset, and advisors’ fees aren’t deductible.

Will we see a trend in which some advisors go back to charging brokerage commissions that are effectively deductible? We may, but there are layers of complexity here. Maybe we’ll see a blend of 50/50 for advisor fees/brokerage commissions.

Astrinos: I’ve said this before and I’ll say it again: The past few months have illustrated the importance of working with a CPA financial planner or tax planner on an ongoing basis to ensure you’re taking advantage of all opportunities to optimize your finances. Also, it goes to show that planning is not a singular event. It’s dynamic, meaning it’s constantly evolving as a result of tax law, financial markets and changes to your personal situation.

I tell my clients that open and regular communication will benefit them because the more I know, the more I can put all the pieces of the puzzle together and perhaps think of creative ways to help them save money. I also think that the changes remind us that everyone should have a financial plan that they use as a flight plan.

It’s understandable that life happens and occasionally people will veer off course, but this is something they should review regularly. When you have a plan in place and know where you’re headed, it’s much easier to take advantage of planning opportunities.