New Tax Law Could Change How Clients Invest: Andy Friedman

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Advisors must help their clients navigate the nuances of the sweeping changes ushered in under the Tax Cuts and Jobs Act, as well as how the new law applies to their specific situations — both now and in the future — as opportunities and pitfalls abound, according to a just-released analysis by former tax attorney Andy Friedman.

In his new paper, Friedman of The Washington Update says that it’s imperative for clients to discuss with their advisors what actions they should consider to “take advantage, or blunt the adverse effects” of the new law.

Individuals’ and businesses’ tax situations can change, Friedman warns, as “many of the provisions” in the law are slated to expire.

For instance, investors may pay “significantly less tax” if they currently pay the alternative minimum tax, have large estates and are actuarially likely to die in the next few years, or own a pass-through business other than a service business, Friedman explains.

However, other investors, Friedman writes, “may not fare so well; they should examine their situation carefully to see if the benefit of the reduction in tax rates exceeds the cost of eliminated deductions.”

Friedman pointed out to ThinkAdvisor some areas that advisors should be focusing on related to the tax law changes. 

Most advisors “are now aware that the new tax law repeals the deduction for investment fees and expenses, such as advisory fees paid in connection with separately managed accounts,” he said. “That change sets up a disconnect between the tax treatment of fees paid on separate accounts and fees paid on mutual funds and variable annuities.”

Unlike investors in SMAs, he continued, “mutual fund and variable annuity investors are able to reduce taxable income by fees paid, because fees are netted against the fund’s or annuity contract’s distributable taxable income. Thus, purely from a fee deductibility perspective, mutual funds and annuities provide a tax advantage.”

On the other hand, “the ability to harvest losses and manage taxes remains a significant advantage of separately managed accounts that could often outweigh the less favorable tax treatment of fees,” Friedman explained. Advisors “should consider with each client the form of investment that provides the greatest after-tax benefit in that client’s situation.”

Changes for Individuals and Businesses

Individuals, Friedman explains in the paper, should also scrutinize the following areas carefully:

“Mutual fund investors effectively may continue to deduct management fees as such fees are netted against the fund’s distributable taxable income,” he said. “On the other hand, the ability to harvest losses and manage taxes remains a significant advantage of separately managed accounts. Investors should review with their advisors the form of investment that provides the greatest after-tax benefit in their situation.”

The Act continues to allow the recharacterization of a traditional IRA contribution as a Roth IRA contribution.

“This recharacterization could be useful where, for instance, IRA asset values have dropped after the conversion date,” Friedman writes. “In such a situation, it could make sense to reverse the prior conversion and consider converting at a later time (after an IRS-mandated waiting period) when tax on the conversion would be imposed at a lower asset value.”

As to changes for businesses, Friedman counsels that businesses should pay close attention to the changes for pass-through entities. Business income earned by those entities (partnerships, limited liability companies and S corporations) flows through to the owners’ tax returns under the new law as opposed to being taxed at ordinary income rates.

The Act “provides a deduction equal to 20% of business income received by owners of a non-service business,” Friedman writes. “Combined with the new 37% top individual tax rate, the deduction results a top tax rate for eligible pass-through business income of 29.6%. The deduction is available only through 2025.”

Small 401(k) plans and master limited partnerships should take heed to the following changes, he points out:

Small-business owners who are eligible to claim the 20% deduction should re-evaluate with their financial professionals the ongoing tax benefits provided by existing 401(k) plans.

“Contributions into the plans will produce tax savings at a 29.6% rate, but distributions from the plans are likely to be taxed at higher individual rates,” Friedman said. “Of course this analysis ignores the significant benefits of tax deferral. If owners conclude that the 401(k) plan produces insufficient ongoing tax benefits, they should consider offering a Roth 401(k) option, which will allow business income to be taxed at the lower rate and participants to withdraw earnings tax-free.”

As to MLPs, energy and investment master limited partnerships that qualify for pass-through treatment are eligible to claim the 20% deduction, to the extent that the MLP reports taxable income and subject to the limitations on the availability of the deduction described above, Friedman explains.

“Some profitable MLPs might consider operating as C corporations to take advantage of the drop in the corporate tax rate, although there are a number of countervailing factors that go into determining whether such a change in structure is advisable.”

— Related on ThinkAdvisor:

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