2018 Tax Reform May Result in State Windfall

Did our state representatives in Congress know all along that 2018 Tax Reform may result in a large shift of taxes from the Federal government to their respective state government coffers?

There is much information on the 2018 Tax Reform bill that is now signed into law and effective for 2018 but little about the effect on state taxes here in Virginia (and likely other states, too). Some taxpayers may find that Line 5 of Schedule A now capped at $10,000 will result in a reduction in itemized deductions for 2018 at the state level. The result of fewer itemized deductions at the state level of-course will increase your state taxes.

State income taxes withheld were never included on the state return but because real estate or property taxes may take you over the new $10,000 cap you may find a surprise when filing 2018 state tax returns.

More taxes due to the state.

Another, even more important, aspect of 2018 Tax Reform is that many more taxpayers will no longer being itemizing deductions because the Federal standard deduction has increased substantially.

If you are one of those who used to itemize and now find that in 2018 your itemized deductions are less than the standard deduction then, if you file using the standard deduction (still optional) you must, in Virginia, also file your state return using the standard deduction.

For singles this is only $3,000 and for married-joint returns it is only $6,000 in Virginia. Yikes! This also could result in large increases in your VA state taxes.

From what I have seen so far, the savings in taxes at the Federal level more than offset any increase in taxes at the state level but you have to run the numbers.

On President Trump and the Pundits

Recently a client asked about a NY Times article about the near-term future of the stock market.

I am very confident that a long-term strategy is essential for investing in the stock and bond markets.

Lately (December 2016 - January 2017), markets have gone up and that feels good but since March 9, 2009 we have had several market drops (2010, 2011, 2012, 2013...then 2015 and 2016). 

Some market downturns were -8%, some -11% and last February 2016 -14%.

That was interesting and disturbing yet the markets did rebound so the long-term strategy is a reasonable approach. 

Someday we will have another more serious market drop (20-30% or more), but we learned from the 1971, 1973, 1984-5, 1991, 2001-2, 2007-9 major market downturns that the recovery occurs for those who wait - it could be 4 years or more. There never is a guarantee though.

The key: if you need cash from your investments within 5 years, then that portion should not be invested in stock funds.

The other key is to have enough "years of safety" to not worry about market pundits and commentaries. 

For every nay-sayer I can find an opposing viewpoint. My advice: ignore it.

Markets many times do go down about 6 months (a leading indicator) before a recession but no recession is expected by economists in the next year (2017) or two (2018). We will see.

Specifically, about this article, the author wrote:

"...“The big picture for investors is this: Trump is high volatility, and investors generally abhor volatility and shun uncertainty,” he wrote. “Not only is Trump shockingly unpredictable, he’s apparently deliberately so..."

And he said: "...it is simply unthinkable that Donald Trump could become our president..."

Well, he got that prediction wrong so why believe any others of his?

For those Christians among us, our trusted Bible says that if a prophet has one false prediction then do not listen to him. Forecasting the future is inherently difficult. 

Of-course the NY Times and the Washington Post are no friends of President Trump.

So another point is always consider the source of the article.

Wait a minute, this article then goes on to say:

"...From the letter, it is hard to divine exactly how Mr. Klarman is investing his fund’s money..."

And...

"...Mr. Buffett campaigned publicly against Mr. Trump, but he has nevertheless invested in the market since his election..."

Yes, indeed, the truth of the matter is that some of these well-known investors may hold 30% in cash but the rest of the money is invested.

It has to be. Earning 1 or 2% on your money is likely not going to meet all of your goals.

On ETFs and INDEX investments which also were mentioned in the article:

It is absolutely true that holding an indexed ETF means that as certain companies become over-valued we own them. We are owning the market as currently valued. 

That is the point, own the market rather than try to beat it which is, for many, a loser's game.

It is also true that value companies (rather than growth companies) and small companies may have a long-term edge, though in reality, the gap in expected returns appears to often narrow over time.

Yes they move up and down at different rates at different times, but not always.

That is why ETFs are separated into these value, growth, large, small, US and international categories as well as bonds and cash within a portfolio.

Diversification is no guarantee and a market downward trajectory will affect anyone invested in the markets short-term. 

There are other investments that stray from "market- cap" (where the size of companies are in proportion within the funds) but all that really is to many advisor's thinking is market timing of some sort or another.

The strategy I subscribe to is to mix small company funds and value company funds in the portfolio to make those kind of adjustments. So, the lesson:

1) maintain a balanced portfolio

2) keep enough years of safety in cash to meet needs (there are other strategies to research too)

3) ignore the market swings and ride out the inevitable downsides (they do occur and will again)

4) read articles and listen to pundits and prognosticators with much skepticism

Talk of a Bear Market?

Many times investors feel that they know what is going to happen next in the markets or the economy and believe that the advisor just does not understand the seriousness of the current situation.

When the markets dived in February 2016 many were sure that was the beginning of a bear market but then the markets recovered rather quickly from that downturn.

A bear market can be defined as a decline of 20% or more.

How long do they last? How often do they occur? One symptom is that it is a time when more investors are pessimistic about the markets.

Advisors (most) do understand the seriousness of the current situation and realize that it has occurred many times over the history of the stock market. They also realize that it is unpredictable.

The key I believe is to have enough in safer investments (cash and cash equivalents) so that you can hang on for the inevitable down market and eventual recovery.

"Years of safety" has been a term used by many planners to prepare for those down periods and one that I subscribe to also. Especially, when in or near retirement this period can be calculated as years - not months. 

How many? Depending on your situation it could be 3, 5, 7 or more years.

If the markets perform like they did in 2007-2009, will share prices go down and never recover their losses? Never? That period lasted about two years and the recovery took another three to four years but, indeed, did recover.

Proposed Tax Changes

I have not written in almost a year (February 2014 was my last post). There is always much to write about though and proposed tax changes are high on the list.

I recall reading Larry Burkett's book back in 1991 titled "The Coming Economic Earthquake" and remembering that he said that tax-deferred accounts only hold promises and not guarantees.

In President Obama's State of the Union address, he touched upon a few tax proposals but in his proposed budget there are even more changes than what he highlighted in his speech.

They are just that, though, "proposed" and unlikely to ever make it into law.

But as Michael Kitces recently writes in his blog "...nonetheless, the proposals provide important insight into what the White House considers..."

Just a few examples of proposals over the last few years, and recently, may give you pause:

(1) No RMD's (Required Minimum Distributions at age 70 and 1/2) if all of your IRA balances aggregated together are under $100,000 or you annuitize a portion of your IRA's to get you under the $100,000 limit. That sounds good.

(2) Eliminating the "back-door" ROTH. This is where you contribute to a Traditional IRA non-deductible contributions up to the limit ($5,500 or $6,500 for 2015 depending on age) and then convert those funds, after a reasonable time, to a ROTH IRA. For those whose income exceeds the ROTH contribution income limits (starting the phase-out at $183,000 of Adjusted Gross Income for 2015) this has been a way to get money into a ROTH. The proposal limits conversions to "pre-tax" dollars only, thereby eliminating any "after-tax" dollars from conversions.

(3) Require minimum distributions (RMDs) from ROTH IRAs. Though still not taxed, under current law, no RMDs are required from ROTH IRAs. They can continue to grow tax-deferred and tax-free with no limits until death and then the beneficiaries are required to take RMDS from inherited ROTH IRAs.

(4) Limit of $3.4 million that you can accumulate and hold in tax-deferred accounts.

(5) Value-add tax or consumption tax (which would, in effect, make ROTH IRAs taxable when withdrawn and spent on something).

That is just a sampling but it holds true that tax-deferral and tax-free accounts are promises from today's government and not necessarily true for the future. Diversify accounts by tax location.

Retirement Withdrawal Strategy

Converting Traditional IRA's and 401k's to a ROTH IRA may make sense from a perspective that is often not considered.

If married, there is a likelihood that one spouse may not survive the other leaving the survivor with a "single status" tax bracket someday. Since the single tax bracket rate is higher, there is a possibility that the survivor will be paying more in taxes - even if on less income.

It may also mean that ROTH conversions that would have been advantageous when married no longer make sense. Staying in the 15% tax bracket if married is easier than trying to stay in the 15% bracket as a single filer.

ROTH Myth

Allan S. Roth writes in the February 2014 Financial-Planning.com magazine that "...a common myth is that the ROTH ... is better than the traditional [IRA] account if the assets are held for a certain number of years. This is false. The only things that matter are the marginal tax brackets in the year of the conversion and the year of withdrawal. If the marginal tax bracket ends up higher upon withdrawal, the conversion will have been beneficial..."

This is just  a number's thing. It is true. Other ROTH advantages, though, may entice someone to do ROTH conversions and/or start a ROTH. There is the 5-year rule for starters so beginning a ROTH sooner rather than later may still make sense to get the clock ticking in your favor. Another is that ROTH's do not have required minimum distributions. And, more importantly, withdrawals never show up on your tax return because it is not taxable income. 

Even if you are in the same tax bracket when you take money out, your social security may be taxed differently if you can minimize your taxable income and that may effect your true marginal tax rate.

Of-course, any money you put into a ROTH can be taken out without penalty or taxes and so this may be a good place to consider for some portion of your emergency fund.

Asset Locations

Where you hold your investments (tax-deferred or taxable accounts) can make a difference. For example, stocks and stock funds held in a tax-deferred retirement account (i.e. 401k or Traditional IRA, etc.) turn a capital gain into ordinary income.

If you are in the 15% tax bracket, the current capital gains tax rate is zero. Putting money into a Traditional IR or 401k will save on taxes right away but it is only a deferral until some later date.

Another possible challenge in retirement is that required minimum distributions will push you into a higher tax bracket when this could be managed by possibly using ROTH IRA's if you qualify or a taxable account.

Another disadvantage is that those tax-deferred retirement accounts do not get a step-up in basis at death but rather are passed on to beneficiaries who then will be taxed on withdrawals in their regular income tax bracket.

Bonds and bond funds held in non-taxable accounts will not grow as fast but interest income is taxed at the same rates as ordinary income.

Tax location diversification makes sense.