January 2018 Letter

Plan Ahead

“He who fails to plan is planning to fail” – Winston Churchill

Another turn of the calendar to a new year reminds us that it’s time once again to make sure our current circumstances align with our long-term goals.  For centuries now, resolutions have been made at the dawn of each year with the aim to make people’s lives better.  In ancient Rome, Romans made annual promises to Janus, the god of beginnings.  Janus was often depicted with two faces, one looking backward and one looking to the future. 

While it’s still early days in 2018, it’s time for us to reassess the recent past and update our plans for the year ahead so that we may stay in step with our long-term financial goals.  For 2018, the recent past is particularly important as it includes passage of the Tax Cuts and Jobs Act of 2017.  In this quarter’s letter we’ll look at some of the major changes in tax policy, what they mean for personal financial planning, and actions you may want to consider early in the year. 

Tax Cuts and Jobs Act of 2017

It wasn’t easy, it wasn’t bipartisan, but the Tax Cuts and Jobs Act of 2017 (TCJA) is now the law of the land.  As surprising as many of the changes were to individual tax policy, equally surprising was the fact that many of the law’s provisions expire in eight years.  Much of the debate and press attention centered on changes to itemized deductions, marginal rates, and corporate taxes, but we begin with a look at the law’s impact on family wealth transfers, a topic near and dear to many of our readers. 

Through the end of 2017, the estate tax rate topped out at 40%, with the first $5.5 million exempted from an individual’s estate ($11 million for a married couple).  Under the TCJA, the top rate remains, but the exemption has been doubled to $22 million.  Importantly, it is estimated that less than 0.2% of all estates will meet this new threshold.  However, like many provisions in the law, the doubling of the exemption is set to expire at the end of 2025. 

Similar changes to the exemption amounts were made to lifetime gifts and generation-skipping gifts.  Keep in mind that transfers made before 2025 escape your estate and are likely never re-captured for estate tax purposes.  Left unchanged, were provisions allowing the unused exemption of a deceased spouse to remain intact and the ability to step up the cost basis of inherited assets to fair market value.  Additionally, last fall the IRS announced that the annual gift exemption of $14,000 would be increased to $15,000 for 2018. 

There are also some important investment related matters to consider.  For instance, 1031 tax-deferred like-kind exchanges will now be limited to real property not held primarily for sale.  Previously, personal property held as an investment was tax-deferred, but no longer.  This could have a profound impact on the collectibles market, including art, classic cars, coins, and fine wines.  Additionally, the bill left the top tax rate of 20% on dividends and capital gains unchanged and kicks in at taxable income of $479,000 for married filers.  The tax rate remains at zero on the first $77,200 of taxable income for married filers, with a 15% rate for everything in between. Unfortunately, the 3.8% Medicare surtax on individual incomes over $200,000 ($250,000 married), survived.  Thankfully, there were no changes to selective tax lot selling, a strategy we use to minimize taxes. 

There were no material changes in the tax treatment of retirement accounts, and retirees age 70 ½ and older can continue to donate IRA assets directly to charity, up to $100,000, and have it count toward their required minimum distribution (RMD), without raising their taxable income.  There was, however, one important change to 529 education savings plans.  529s can now be used to fund K-12 tuition expense.  While this flexibility is nice, the cost of college isn’t going down and money used now isn’t available later.  Don’t forget the rule of compounding!

On the individual side, the most contentious part of the new tax law are the changes to itemized deductions.  Many deductions affect people in different ways depending on income levels and residency, especially the exemption cap on state and local taxes (SALT).  One change that hits everyone is the mortgage interest deduction.  The interest deduction will now apply to mortgages up to $750,000, down from $1,000,000 previously.  Mortgage loans taken before December 15, 2017 are grandfathered and homeowners can continue to refinance existing debt up to the previous cap of $1 million.  The TCJA, however, does away with interest deductibility for home equity loans.  Of course many of these “lost” deductions are offset by the reductions in tax rates and/or the much higher threshold to fall victim to the unpredictable and complex Alternative Minimum Tax (AMT). 

On the plus side, there were no changes to the exclusion amounts used for calculating capital gains on the sale of a primary residence.  You may still exclude $500,000 (married, filing jointly) in gains on your personal residence, as long as you have lived there two of the past five years.  Most of the remaining changes to the tax code are too personal or nuanced for the scope of this letter and we recommend you meet with your tax advisor early in the year to see what, if any, changes need to be made.  We should note, however, that tax-preparation expenses, along with other advisory expenses, will no longer be deductible, at least through 2025.

2018 Financial Planning Strategies

With major changes occurring to the U.S. tax code this year, it’s as important as ever to start the year with a plan.  Changes to the tax code could affect major spending decisions you may make, including major home related projects, estate planning/gifting, healthcare, retirement, and charitable giving.  Let’s look at each of these items in a bit more detail:

  • Housing:  The new year is a good time to look at any needed projects around the house.  With the loss of the home equity interest deduction, financing major renovation projects could be more expensive than originally thought, particularly if interest rates rise.  You may also want to consider consolidating any outstanding home equity lines into your primary mortgage as long as you stay below the $750,000 total mortgage threshold.  It’s also important to note that interest expense on a second home can be deducted only when the aggregate mortgage debt of both the primary residence and second home is below the $750,000 threshold.  This reduction from $1 million to $750,000 could be especially painful for future mortgages if historically low mortgage rates become a thing of the past as the economy grows.
  • Estate Planning/Gifting:  With the increase in the annual gift exemption to $15,000, you may want to consider if your gifting needs will increase this year and budget accordingly.  Also, consider your gifting needs in light of the change to 529s, opening them up to K-12 tuition.  Estate planning is more complicated.  While it’s great that the estate exemption levels were doubled, they do revert back to current levels in eight years and there could be increased political uncertainty with any leadership changes in Washington between now and then. 
  • Healthcare:  Under the new tax law, 2018 could be an important year for budgeting your healthcare needs.  Previously, only healthcare expenses exceeding 10% of adjusted gross income (AGI) could be deducted.  The new law lowers the threshold to 7 ½% for all taxpayers, but only for 2017 and 2018.  This could be an important consideration later in the year if you’re contemplating a major elective procedure.
  • Retirement:  There were no meaningful changes to rules governing retirement accounts under the TCJA.  But, now is a good time to review any contribution adjustments that may be needed on your part this year.  Generally speaking, while you’re still working, it’s usually a good idea to maximize contributions to tax-advantaged accounts.  Again, the rule of compounding!  January is also a good time to ascertain this year’s RMD and factor that into your budget assumptions. 
  • Charitable Giving:  Now’s the time to also think about charitable giving in 2018.  The charitable deduction was spared in the TCJA and in fact was increased from 50% of AGI to 60% of AGI.  However, you must still itemize to claim charitable deductions and this itself may be more difficult given the higher threshold of the increased standard deduction.  There are two possible workarounds to consider.  The first is “bunching” your contributions every few years in order to meet the higher standard deduction.  The other idea is to consider starting a donor-advised fund (DAF).  DAFs are charitable accounts that can be established with an upfront contribution large enough to qualify for a charitable deduction.  Then, the donor has the flexibility to make contributions from the account to qualifying organizations at their discretion in subsequent years, while the unused money earns a tax free return.

These are just a few tips to get you started thinking about 2018.  It’s important to review, or in some cases establish a plan to meet your financial needs for this year and beyond.  2017 was an extraordinary year and as asset prices change and markets move at different speeds, we are constantly monitoring portfolio asset allocations and now would be a good time to review any necessary changes brought on by changing income needs or updated long- term financial goals.  At Covington, we can assist you in this financial planning process.  For instance, “how will making large gifts now effect my future cash flow needs?”  Or, “do I have enough to retire?”  We can help with that and other questions you may have as you look ahead.

Cuts For Businesses Too

The TCJA not only changed the individual side of the tax code, but will also have a profound impact on corporate America.  Although it wasn’t evident in the passing of this law, historically there has been a bipartisan consensus that U.S. corporate tax rates were too high and uncompetitive.  As we write this, corporate CFOs are busily assessing the changes in the law and what it means for future capital allocation decisions as the law unlocks cash held abroad and increases profitability with lower U.S. tax withholdings.  We hope to learn more from our portfolio companies as they report earnings in the coming days, but already, markets have begun to price in higher corporate profits in 2018 and beyond.  Benefits to companies in our portfolios will vary given that many of them already derive a significant portion of their earnings from lower-tax, international markets.  But, we would expect most, if not all, of our holdings to benefit from freer flows of capital, and if many leading economists are right, a higher rate of economic growth.  

Finally, one last tip; be sure to review your insurance policies.  In light of last year’s natural disasters, particularly the wildfires here in California, it’s critical that you review all of your coverages to ensure that your belongings are adequately protected in the unlikely event of a natural disaster.  From all of us at Covington, we wish you a safe, happy, and prosperous New Year!  And, as you contemplate your financial plan for the year ahead we leave you with these words from Warren Buffett.

“Someone's sitting in the shade today because someone planted a tree a long time ago.” 
Warren Buffett