Health care reform and tax reform were two cornerstones of the platform that landed President Donald Trump in the White House and Republicans in control of both houses of Congress last November.
For investors, tax reform could have major implications on the amount they can save each year and the types of returns they can expect from their investments.
But until a tax reform bill is passed, investors have only the one-page handout the White House provided to reporters in April as a guide. The handout promised “the biggest individual and business tax cut in American history.”
According to the outline, Trump wants to reduce the number of income tax brackets from seven to three, with tax rates of 10 percent, 25 percent and 35 percent. The outline provided no details about the boundaries of the brackets.
Most importantly for investors, the outline made no mention of changes to the capital gains tax, which is a critical part of long-term investing returns.
The current rules. Under the current system, capital gains are divided into short-term gains and long-term gains. For investors who buy and hold assets for at least a year, returns are taxed at the long-term rate. As of 2016, 99 percent of Americans paid either a zero percent or 15 percent long-term capital gains rate.
Capital gains brackets are directly tied to income tax brackets. Taxpayers in the 10 and 15 percent marginal income tax brackets pay zero percent rates for long-term capital gains. Those in the 25, 28, 33 and 35 percent marginal income tax brackets pay a 15 percent long-term capital gains rate.
And only those who fall in the 39.6 percent marginal income bracket (earning more than $418,400 in 2016) pay a 20 percent long-term capital gains rate.
Potential changes. Trump has made no mention of drastic changes to the capital gains tax rates themselves. The key change for long-term investors could be exactly where the bracket boundaries will fall and whether or not they will remain tied to income tax brackets.
During his campaign, Trump proposed $37,500 and $112,500 as the income boundaries separating his three individual income tax brackets. However, without updated details from the White House and without any indication of where Congress stands on the matter, those proposed brackets offer investors little more than a guide to where the debate process could potentially start.
With so much about tax reform left up in the air, investors may be nervous about how changes to the tax code might impact their retirement savings or financial goals.
Rebecca McElroy, tax partner at Maddox, Thomson & Associates in Houston, says investors should certainly be paying attention to how tax reform plays out. In addition to changes to the capital gains brackets, McElroy says repeal of the net investment income tax, elimination of the estate tax and simplification of the tax code could all impact investors.
“Trump’s proposed cut in rates, including elimination of [the net investment income tax], is the area of tax reform I believe will have the greatest impact on investors,” McElroy says.
“While the president’s plan does retain preferential tax treatment for long-term capital gains, many middle-income investors may experience a dramatic drop in their tax burdens, regardless of whether or not they benefit from a special tax rate to long-term capital gains.”
Winners and losers. Investors may experience lower effective tax rates if the Republicans can pass their tax reform plan. But stock investors could also benefit from the impact the plan will have on American companies as well, says Mike Loewengart, vice president of investment strategy at E-Trade.
“If corporate taxes are cut to as low as 15 percent, as Trump has pledged, investors could see a boost in domestically focused companies – specifically, homegrown consumer discretionary, consumer staples and industrials,” Loewengart says.
At the same time, tax reform could be a blow to other U.S. companies.
“Investors in autos and retailers would be wise to keep an eye on if the administration follows through with a border adjustment tax, as many of those companies could be in the crosshairs for their reliance on imported goods,” Loewengart says.
He also says tax reform could trigger an outflow from municipal bonds, which have long been considered a staple for tax-conscious investors due to their tax-exempt status.
Some things never change. But while savvy investors may be able to tweak their investment style to maximize the potential long-term benefits of tax reform, TD Ameritrade chief strategist JJ Kinahan says investors will always be able to rely on the same principles of long-term success – no matter how the tax code changes.
“The tax proposals are interesting, and any investor should be aware of them. However, as with any proposal, an investor should not trade on rumor,” Kinahan says.
Without knowing exactly what tax reform will look like or if it will be passed, investors jumping the gun may be setting…
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