January 1, 2018 ushered in a new era of tax policy as the Tax Cuts and Jobs Act’s sweeping changes to the tax code went into effect. While initial polls have shown some skepticism on the part of the general public with respect to the bill, most analysis has shown that the vast majority of taxpayers are likely to see their tax bills go down and their after-tax incomes increase, at least in 2018. The sunsetting of many provisions related to individual tax rates means that unless other action is taken, after 2025 almost everyone could see a significant increase in their tax rates. Here we, like Congress, will focus on the immediate impact (i.e. 2018–2025) and worry about those more distant years later.

This projected decrease in taxes is true even in states with higher state income tax rates and (on average) across all income brackets. One of the more controversial aspects of the bill was the limitation of the amount of state and local taxes that can be itemized as deductions to a maximum of $10,000. The media portrayed this as an issue primarily for blue states with high tax rates. The facts don’t fit quite as neatly into that narrative, however. California and New York with their high state tax rates and Texas with no state taxes certainly support that assertion, but there are a good number of more conservative states with relatively high tax rates of 6%+ (e.g. Georgia, South Carolina, Nebraska, Arkansas, and others) while left-leaning Washington state has no tax.

The new tax code does present a bit of a paradox for some investors, though. While the effective tax rates for the most part will decrease, the marginal tax rate for many investors may actually increase. We would argue that it is one’s marginal tax rate that is most relevant to consider when evaluating the tax drag on your investment portfolio and the impact that tax management techniques can have on mitigating that tax drag. So, even though your tax bill may have gone down, it may be more important than ever to consider the implications of taxes on your investment portfolio.

Long-term capital gains and dividends
For most equity portfolios, the tax rate that applies to long-term capital gains1 and qualified dividends is probably the most important rate to consider. Unless the strategy involves very high levels of turnover, most of the returns are likely to be generated from long-term capital gains (i.e. positions held for at least one year) and dividends. In states with no state income tax such as Texas, Florida and Washington, most investors in the top tax bracket will see little change in these marginal rates. The top rate remained at 20% plus the 3.8% Net Investment Income Tax (NIIT)2. In any state where state income taxes are assessed, however, the marginal rate for most taxpayers has effectively increased when combining federal and state taxes, due to the inability to itemize those state taxes as a federal deduction beyond $10,000. The set of columns on the far right of Figure 1 illustrates this result for California taxpayers, where the effect is most pronounced. Under the old tax code, investors paid a marginal rate of 31.3% on long-term capital gains and dividends. This was composed of a 20% federal rate, 3.8% NIIT, 13.3% state rate and an effective reduction of federal taxes equating to 5.8% (assuming no phase-out of deductions). Under the new tax code, those state taxes (on the margin) are likely no longer deductible for most of these taxpayers – meaning they will lose the benefit of this deduction. Even in states with more modest rates of 5%, taxpayers will see the applicable rate increase by over 8% on a relative basis.

Insights TaxCutPortfolioImpactF capital gains rate
The old tax rates reflect the tax rates for high income investors prior to the Tax Cuts and Jobs Act going into effect on January 1, 2018. The new rates are those for high income investors that have been in effect since then.

Short-term capital gains, interest and non-qualified dividends
Other types of investment portfolios might be more affected by changes in the ordinary income tax rates,3 which apply to short-term capital gains,4 interest income and non-qualified dividends. The types of strategies where this would be more relevant would include taxable bond portfolios, Real Estate Investment Trusts and very high turnover equity portfolios. Figure 2 illustrates some of these effects. In states with no state income tax, most investors in the top income bracket will see a modest reduction in their marginal tax rates as the top federal rate has decreased from 39.6% to 37%. In states that do assess state income taxes, however, the combined federal and state marginal tax rates applied to ordinary income may actually increase, depending on the state tax rate. If the state tax rate is higher than about 6%, the loss of deductibility of state taxes will more than offset the reduction in the federal rate. High income taxpayers in California, with a top state tax rate of 13.3%, will likely see the biggest impact, with marginal tax rates increasing by 3.2% from 50.9% to 54.1%, a relative increase of over 6%. Investors in many other states may see effective increases as well, however, as 23 states plus the District of Columbia all have state rates that are 6% or greater.

Insights TaxCutPortfolioImpactF ordinary income
The old tax rates reflect the tax rates for high income investors prior to the Tax Cuts and Jobs Act going into effect on January 1, 2018. The new rates are those for high income investors that have been in effect since then.

Conclusions
As with any tax-related issue, each individual’s situation is likely to be different based on specific circumstances. The analysis above is based on very generic characteristics of high income taxpayers. Other considerations such as the alternative minimum tax (AMT)5 and the phase-out of deductions may affect how marginal tax rates might change. Also, for investors that are not in the top income brackets, there may be modest decreases in marginal tax rates but many of the same issues regarding the impact of the loss of deductibility of state and local taxes may also apply. There are some general conclusions that can be drawn regarding investment portfolios under the new tax regime:

  • While there may be some modest decreases to effective tax rates for most investors, effective and marginal tax rates remain at levels that can generate significant tax drag on investment portfolios. Considering taxes is a critical component to investment success. Research has shown that taxes can erode 1%–2% or more of an investor’s pre-tax returns and can have an impact that is as large as or larger than fees.
  • Investors in states with higher state income taxes may see an increase in their marginal tax rates for capital gains, dividend and interest income, meaning that even though their tax bill might go down in 2018, the tax drag on their investment portfolio, and the benefit that can be derived from applying tax management techniques, are likely to increase.
  • Tax liability in an investment portfolio can be mitigated meaningfully by applying a number of tax management techniques, including:
  • Tax loss harvesting,6 which entails realizing losses on investments that have declined in value to help offset realized gains and reduce tax liability. In our opinion, this presents probably the best opportunity for reducing tax liability.
  • Selecting the optimal tax lot, rather than resorting to First In First Out or some other standard approach, can help reduce the magnitude of the gains associated with selling part of a position. There was some discussion about forcing the use of First In First Out accounting in the Senate version of the bill, but fortunately this was not included in the final version that was signed into law.
  • Deferring sales of investments that would result in a short-term capital gain until they qualify for the lower long-term capital gains tax rate can also help reduce tax liability.
  • Avoiding wash sale rule violations, where a purchase of a security is made within 30 days of realizing a loss on the same or a similar investment, can ensure that those losses can be applied to offset other gains in that tax year.
Taxes are just one of several factors that should be considered when executing an investment plan, but one that is often overlooked. Clients are best served when investment, tax and financial planning are done in a coordinated manner. This may often require collaboration between tax and investment professionals, but the result of doing so can have a powerful impact on helping clients achieve their investment objectives.
Source: Natixis Advisors, L.P.

NATIXIS INVESTMENT MANAGERS

Natixis Investment Managers serves financial professionals with more insightful ways to construct portfolios. Powered by the expertise of more than 20 specialized investment managers globally, we apply Active Thinking® to deliver proactive solutions that help clients pursue better outcomes in all markets. Natixis ranks among the world’s largest asset management firms7 ($1,004.5 billion AUM8).

1 A gain from a qualifying investment owned for longer than 12 months and then sold. The amount of an asset sale that counts toward a capital gain or loss is the difference between the sale value and the purchase value. Long-term capital gains are assigned a lower tax rate than short-term capital gains in the United States.

2 Tax on income received from investment assets (before taxes) such as bonds, stocks, mutual funds, loans and other investments (less related expenses).

3 Tax on income at ordinary income rates. Ordinary income is composed mainly of wages, salaries, commissions and interest income (as from bonds).

4 A capital gain realized by the sale or exchange of a capital asset that has been held for exactly one year or less.

5 AMT prevents taxpayers from using breaks to escape their fair share of liability by recalculating taxes according to a specific formula.

6 Selling securities at a loss to offset a capital gains tax liability.

7 Cerulli Quantitative Update: Global Markets 2019 ranked Natixis Investment Managers (formerly Natixis Global Asset Management) as the 17th largest asset manager in the world based on assets under management as of December 31, 2018.

8 Net asset value as of September 30, 2019. Assets under management (“AUM”), as reported, may include notional assets, assets serviced, gross assets, assets of minority-owned affiliated entities and other types of non-regulatory AUM managed or serviced by firms affiliated with Natixis Investment Managers.

Natixis Investment Managers does not provide tax or legal advice. Please consult with a tax or legal professional prior to making any investment decisions.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed may change based on market and other conditions.

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Natixis Advisors, L.P. provides advisory services through its divisions Active Index Advisors® and Managed Portfolio Advisors®. Advisory services are generally provided with the assistance of model portfolio providers, some of which are affiliates of Natixis Investment Managers, L.P. • Natixis Distribution, L.P. is a limited purpose broker-dealer and the distributor of various registered investment companies for which advisory services are provided by affiliates of Natixis Investment Managers. Natixis Distribution, L.P. and Natixis Advisors, L.P. are located at 888 Boylston Street, Suite 800, Boston, MA 02199-8197. • 800-862-4863 • im.natixis.com

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