Investing Under the New Tax Laws

February 6, 2018

There was an endless debate during 2017 about tax reform and who should be the greatest beneficiary of the changes. In the end, tax rates are lower for most individuals and corporate tax rates will be significantly lower under the Tax Cuts and Jobs Act of 2017.

The tax code is still complex, and the changes didn’t do anything to simplify it, which was one of the goals of reform. The immediate response by the markets has been positive and the tax cuts are expected to boost the economy during the year as individuals enjoy more money in their paychecks and companies invest some of their tax savings into growing their businesses and better compensating their workers. Higher dividend payments to shareholders due to the tax savings will also find their way back into the economy.

In general, investment and retirement planning strategies were not significantly changed by the tax reform. However, passive investments in income-producing real estate will greatly benefit as the income generated will qualify for a 20% deduction.

Favorability of Passive Real Estate Income

Income from passive real estate investments, if structured properly, will be taxed at 20% off one’s marginal tax bracket. Someone in the highest 37% tax bracket will be taxed at 29.6% on their real estate income while someone in the 24% tax bracket will be taxed at 19.2%. These examples apply to passive investors in property as the rules are different for active investors whose primary business is real estate. Everyone should consult their own tax accountant concerning their passive real estate investments as individual situations differ.

This is the first time that real estate income has been taxed at a tax-advantaged rate and real estate investments still get the tax benefits of depreciation deductions and interest expense deductions, both with some limitations.

Favorable to Qualified Dividends

One of the real benefits in the tax code is the treatment of qualified dividends. Shares of companies like Kraft Heinz, Merck, Chevron, Coca-Cola, Pfizer, and Procter & Gamble pay qualified dividends of greater than 3% while companies like Verizon and AT&T pay better than 4%. Those qualified dividends are taxed at a lower rate than one’s ordinary tax rate.  If a single taxpayer earns $50,600, they will be taxed at 12% on their income at that level but dividend income up to that level will be tax-free.

The qualified dividend benefit is meaningful to a retiree that lives off their investment income.  The retiree could put their money in the bank and pay a 12% tax on the interest the bank pays or they could invest in companies that pay qualified dividends and pay no tax up to the $50,600 limit. Above that, the tax rate goes to 15% and at higher income levels goes to 20%. But at all levels of income, qualified dividends are taxed less than earned income or interest income.  Married couples can earn up to $101,200 in qualified dividends and pay no tax on those dividends if that is their only income.

Roth Accounts

The retirement savings system in our country is too complicated with so many types of accounts and choices between traditional retirement accounts and Roth retirement accounts.  With the new lower tax rates, more savers may want to consider Roth contributions as the value of a tax deduction is worth less when tax rates are lower.

Roth contributions don’t get any current tax deduction but all future growth in the account is tax-free when used in retirement. If tax rates go back up in the future, the value of having Roth accounts increases. Just as it is advisable to pay off the mortgage and other debt before retirement, saving more in Roth accounts helps reduce or even eliminate tax liabilities in retirement.

Consider Health Savings Accounts

One account that gets little attention and low participation rates is the Health Savings Account. Health Savings Accounts are still allowed under the new tax code. They allow participants to contribute up to $3,450 for an individual or $6,900 for a family and an additional $1,000 if 50 or older. The contribution gets a tax deduction and any growth in the account will be tax-free if used for medical expenses in the future.

An astute saver will max out the HSA and allow the account to grow to be used in retirement for medical expenses. Just like the Roth IRA, this type of account provides tax-free growth, and in addition, it provides a tax deduction. The accumulated funds in an HSA can be invested in growth-oriented mutual funds. Financial planners should encourage savings in HSA accounts in addition to Roth accounts for those that work for companies that offer one.

Expanded 529 Opportunities for Parents

Many parents have been saving for their children’s college education in 529 Plans. These accounts allow funds to be invested and the growth is tax-free if used for higher education.  Under the new tax code, funds in these plans can now be used for private education for kindergarten through high school. The additional flexibility of the 529 Plans is a welcome change and may encourage more use. Grandparents can also help the next generation by funding 529 Plan accounts. Savings in 529 Plans can be transferred to siblings if necessary.

A Time to Consult the Professionals

There are many more details to what is still a very complicated US tax code. Working closely with your financial and legal professionals is always advisable if not necessary when major changes in tax law such as the Tax Cuts and Jobs Act of 2017 occur.

Keep in mind the tax rate changes that affect individuals expire at the end of 2025. Also, the 3.8% additional tax on investment earnings due to the Affordable Care Act on incomes over $200,000 for single taxpayers and $250,000 for married taxpayers still applies unless the ACA is repealed.

Overall, we’re hopeful. If the intended economic benefits resulting from the taxation side of our fiscal policy come to fruition, it’s likely that more people will participate in the economy not only as producers and consumers, but savers and investors as well.