Advisors Eye Tax Reform Uncertainties, Implications To Clients

While Congress continues to debate the most massive overhaul of taxes since the 1980s, financial advisors are doing the same.

Advisors disagree on how to handle the waiting on whether state and local tax deductions will be lost, but all say clients and advisors have to be aware of the possibilities and poised to act.

“It seems to be a done deal that taxpayers will no longer be able to deduct state and local taxes from federal income tax,” said Bernard Kiely, founder of Kiely Capital Management Inc. in Morristown, N.J. “But I’m afraid, other than moving, there may not be much a person can do” to combat the increase in taxes that many will be subject to in high tax states like New Jersey.

“The increase in the standard deduction will not make up for the loss of the itemized deductions here,” he said.

“There will have to be a reconciliation between the House and Senate versions of the bill and it is still very fluid and happening quickly,” agreed Harry Scheyer, senior vice president with RTD Financial Services based in Philadelphia. “I would never tell someone to pay taxes ahead of time. But it is going to be tough to wait and see what happens.”

Robert Klein, founder of Retirement Income Center based in Newport Beach, Calif., agrees it may be too early to act. “I educate clients that proposals are just proposals, even though there is a good chance this one will become law.”

“We can’t do any actual tax projections yet,” he added. “To the extent that state income tax payments might be able to be accelerated to this year, clients might want to consider that option, unless it forces them to pay the AMT [alternative minimum tax]. We are always looking at the best time to pay state taxes.

“In places like New Jersey it is easy to hit $10,000 in property taxes [the proposed limit for deducting property taxes], so people may want to accelerate some of that payment to this year,” Klein said.

Many states outside of New York, New Jersey and California have high marginal tax rates for high-income earners. In South Carolina, the top rate is 7 percent. Joe Taylor, principle at Myrtle Beach, S.C.-based Oak Street Advisors, said that the uncertainty regarding passage and final format of the tax bill makes it challenging to plan ahead, but agreed with Klein’s move to take deductions in the 2017 tax year.

“The final content of any tax rewrite is uncertain, but… we think it would be prudent to accelerate the deduction where possible,” said Taylor. For advisors, that would mean recommending that clients withhold more state and local taxes in the 2017 calendar year, and arranging for retirees and self-employed clients to make any estimated tax payments for January 2018 in December 2017 instead.

“The worst that happens is that you get a refund in 2018 for taxes withheld in 2017, and a 1099G for that refund will be taxable in 2018 and payable in 2019,” said Taylor. “Presumably, your tax rate will be lower in 2018, with an emphasis on 'presumably,' so you’ll have effectively saved the difference in income tax rates between 2017 and 2018.”

Other advisors are holding off on talking to clients but are closely watching the congressional proceedings.

Caitlin Chen, director of financial planning at Edelman Financial Services, which is based in Fairfax, Va., said, “Since the bill has not been passed and will likely change, we are not currently talking to our clients about the proposed bill. As it is written, the pending bill may or may not even pass.

“However, as a firm, we are closely monitoring the proposal and, should it be signed into law, we will then perform our own comprehensive analysis of these changes. We will then explain to our clients and their families how these changes can impact their own individual financial plans and what action steps may need to be taken,” said Chen, who is in the Long Island, N.Y., office.

At Warwick Rathbone, a Boise, Idaho-based RIA, advisors are trying to push off the tax conversation until they feel more certainty around potential reforms, said principal Ryan Warwick.

“It’s speculation and it’s outside of our control,” said Warwick. “We have no idea what Congress may or may not do at the end of the day, but we’re still going to be running tax-efficient portfolios.”

Two or three clients out of every 10 at PagnatoKarp, a wealth management and family office firm in Reston, Va., are asking questions about the tax proposal, according to Paul A. Pagnato, founder and CEO.

“Individuals may be motivated to accelerate any itemized deductions they can take this year rather than next because the deductions may be gone next year,” Pagnato said.

Warwick, a CPA and CFA, is keeping a close eye on whether the proposal to eliminate state and local tax deductions survives in the final version of the tax bill.

“If they take the state and local deduction away, you would assume that the alternative minimum tax (AMT) falls away also, so for the 5 million people who have to pay the AMT it doesn’t change anything,” said Warwick.

“This will probably be a small improvement for many taxpayers,” acknowledges Warwick. “Here’s my fear: When you go back as far as the 1980s, we had really high tax rates but we were deducting things like credit card interest, auto loan interest and other items. Americans were paying higher rates, but had lower taxable income. As time went on, we started to peel back the deductions, but rates went down. In recent years, the deductions have still been peeled back, but rates started to go back up as well. It’s a bait-and-switch. We never got back the deductions.

“We’ll end up getting more taxable income and paying at higher tax rates over time. I’m concerned for the long term on that basis.”

Warwick is also watching Congress's plans to roll back or eliminate the federal estate tax, but moving forward with estate planning under the assumption that the tax will be restored at some point in the future.

The two changes that may make more of an impact than the loss of the state and local tax deduction for PagnatoKarp clients is the limit on the deduction for mortgage interest and the proposed requirement that changes tax loss harvesting strategies. Under the proposed bill, stocks and bonds would have to be sold in the order they were acquired [first in, first out] rather than by which ones are losing money.

The real estate market also will be affected. “People will move because of this,” Pagnato said. “We have already had clients who lived in Maryland move to Virginia to take advantage of lower taxes.” This will exacerbate that trend.

“In the future, investors are going to be even more in tune to tax efficient investing. States may also change taxes to not lose residents,” Pagnato said.

Weinstock Manion, a law firm based in Los Angeles that deals with high-net-worth individuals and families, has received more inquiries about the proposed estate and gift tax changes than the loss of local and state tax deductions, said Jeffrey P. Geida, a lawyer with the firm. “For the most part we are telling our clients to wait to see what is finalized.”