Happy New Year! We hope that you had a joyous holiday season surrounded by friends and family.

The year 2017 began and ended on somewhat similar notes. In January, the stock market rose on hopes that newly proposed tax cuts would boost corporate profits and spur economic growth. As the year came to a close, a sweeping tax reform package passed and markets continued their upward trend as individuals and corporations digested the implications.

Overall, equity markets worldwide added to their impressive 2016 gains. After four years of U.S. stocks outperforming foreign markets, the tide changed in 2017 with foreign stocks

leading the way and notching a 27% return. Bonds also generated positive returns for the year, even as the Federal Reserve raised interest rates three times and advertised the potential for additional hikes in 2018.

Asset class returns for the quarter and the full year were as follows:

Index

Asset Class

Fourth Quarter 2017

Full Year 2017

Barclays U.S. Government/Credit

Bond Index Intermediate

Fixed Income

‐0.2%

2.1%

S&P 500

Large U.S. Stock

6.6%

21.8%

Russell 2000

Small U.S. Stock

3.3%

14.7%

MSCI ACWI ex‐USA

Foreign Stock

5.0%

27.2%

S&P Global REIT

Real Estate Securities

3.0%

7.4%

 

The impressive year for stocks was unusual in that it lacked any meaningful declines. Despite an undercurrent of political volatility, stock market volatility was almost nonexistent.

The S&P 500 has not suffered a significant pullback since prior to the 2016 election; in fact, it posted a positive total return in each and every month of 2017. Volatility metrics have been well below historical norms. Recognizing that it is nearly impossible to forecast the cause, magnitude, or timing of the next market retreat, it would not be unusual for volatility to return in 2018. Accordingly, we remain focused on rebalancing to our asset allocation targets for each client as we move into the new year.

The Tax Cuts and Jobs Act (TCJA) of 2017 is now in effect

After prolonged negotiations between both houses of Congress, significant federal tax reform was signed into law by the President in the final week of 2017. What began as a Republican‐led blueprint for a simplified tax system in late 2016 became a 500+ page bill in its final form. The new tax laws will affect the vast majority of individuals and businesses through revised tax rates, as well as some noteworthy changes to deductions.

Some of the changes resulting from the TCJA and potential tax saving strategies under the new rules are highlighted below:

The number of income tax brackets remains the same with lower rates across the board for individuals and corporations.

The highest individual marginal tax rate is now 37%, and most brackets have been lowered and expanded. The individual tax rate changes are temporary through 2025, whereas the corporate tax rate has been permanently reduced from 35% to 21%.

  • Potential Strategy: In years where income is expected to be lower, consider a Roth IRA conversion, paying taxes on the conversion amount at a lower income tax bracket and allowing the money to grow tax‐free in the future. Additionally, maximizing retirement plan contributions can help lower current taxable income.

The standard deduction doubled with personal exemptions eliminated.

The personal exemption (formerly $4,050 per person) has been eliminated entirely, potentially affecting larger families. The standard deduction has been doubled to $24,000 for married couples ($12,000 for single filers), creating a higher hurdle for itemizing deductions. The Pease Limitation, which reduced itemized deductions for high earners, has been repealed. The Alternative Minimum Tax (AMT) remains in place for individuals, but the expanded phaseout and limits to deductions will likely make the AMT applicable to far fewer taxpayers.

  • Potential Strategy: Consult your tax professional to determine the deductions you are eligible for and whether taking the larger standard deduction or itemizing deductions will be more beneficial. Moving deductions from one year to another by changing the timing of payments will likely be an effective strategy for those on the borderline of itemizing under the new rules.

Charitable donations may be more strategic.

The limitation on charitable cash contributions will now be 60% of adjusted gross income (up from 50%).

  • Potential Strategy: Consider bunching charitable gifts in years where the deduction is most beneficial. This may be accomplished by utilizing a Donor‐Advised Fund or charitable trusts. A Donor‐Advised Fund allows the donor to front‐load contributions (taking the deduction in the year made) and maximize the charitable deduction in years when itemizing deductions.

Popular itemized deductions such as state/local taxes and mortgage interest remain in place but are now more limited.

The itemized deduction for state and local taxes (which includes property taxes) is capped at $10,000 for both individual and married filers. In the past, this deduction has been unlimited (subject to AMT adjustment) and will remain so for rental real estate. For future home purchases, the itemized deduction for mortgage interest will be limited to a principal amount of $750,000 used to acquire, build, or substantially improve a primary residence or second home. The previous $1 million limit will remain in effect for existing loans and future refinancing of those loans on a primary residence or second home, but not additional borrowing. A notable change is the complete elimination of the interest deduction on any home equity indebtedness for both new and existing loans.

  • Potential Strategy: Examine the interest rate to determine if borrowing under the line of credit still makes sense now that the interest deduction is no longer allowed.

Estate taxes remain, but the exemption amount has been raised significantly.

The federal estate tax and generation‐skipping tax exemption amounts doubled to $22.4 million for couples ($11.2 million per person) with portability. Step‐up provisions and generation‐skipping tax rules remain intact. For those who make gifts, the annual gifting limit increases from $14,000 to $15,000.

  • Potential Strategy: Even though very few families will be exposed to estate taxes, we consider estate planning tools such as revocable trusts to be as important as ever to avoid probate and control the distribution of assets to beneficiaries.

A new deduction for qualified business income.

A new 20% deduction for Qualified Business Income (QBI) includes “pass‐through” income from not just legal entities such as partnerships and S corporations, but also sole proprietorships, rental real estate, trusts and estates, and real estate investment trusts. This means certain pass‐through entities could be taxed at 80% of their normal tax bracket. However, the rules are very complex as there are phaseouts for certain types of personal service businesses and other limitations. This area is ripe for strategic consultation with your tax advisors.

  • Potential Strategy: If you have pass‐through income, discuss this with your attorney and/or tax professional to evaluate your business structure and determine the optimal arrangement for tax purposes.

The elimination of all miscellaneous itemized deductions.

The itemized deductions for tax preparation and investment advisory fees associated with taxable accounts have been eliminated, along with all other miscellaneous itemized deductions. For many high earners, these fees were already not deductible as they did not exceed the 2% of adjusted income floor. Investment management fees drawn directly from IRA accounts will continue to receive the benefit of being paid with pre‐tax dollars, effectively receiving treatment as a tax deduction.

Preferential rates for long‐term capital gains and qualified dividends remain.

Both long‐term capital gains and qualified dividend income are now linked to specific dollar thresholds rather than income tax brackets: the 0% capital gains rate remains intact for married couples with incomes under $77,200, which provides a significant planning tool for retirees; those between $77,200 and $479,000 in adjusted income fall into the 15% rate; and married filers with income over $479,000 are in the higher 20% rate.

The 3.8% Medicare tax on net investment income remains intact for high earners, producing a maximum capital gains rate of 23.8%.

  • Potential Strategy: We employ tax loss harvesting and asset location strategies with the objective of optimizing after‐tax returns for clients. We also help clients develop tax efficient portfolio withdrawal strategies to take advantage of lower capital gains rates, when possible. Coordination among you, your D&Y team, and your tax advisor is crucial in ensuring that tax savings are achieved.

Families with children receive new incentives.

Funds in 529 college savings plans can now be used for elementary and secondary school expenses up to $10,000 per student per year. Under the former law, 529 plan funds could be used only for college expenses to qualify as a tax‐free withdrawal. The adjusted gross income phaseout for the Child Tax Credit has been increased dramatically (from $110,000 to $400,000 for married couples) along with a doubling of the credit from $1,000 to $2,000 per qualifying child under the age of 17.

  • Potential Strategy: For families with young children who may be attending private elementary and secondary schools and eventually college, a 529 plan may now be the ultimate savings vehicle. Given the higher gifting amounts available, families can potentially “front‐load” contributions into a plan or contribute on an ongoing basis.

This is not an all‐inclusive list, and you should consult your tax advisor to determine how the new laws may affect your unique situation. Managing income taxes for our clients has always been a focal point of our investment strategy, and proactive tax planning can have a dramatic effect on long‐term returns. We continue to work closely with our clients’ tax advisors to maximize tax savings and adhere to tax compliance standards.

Tax Season and New Reports

In mid‐February, clients with taxable accounts can expect to receive Form 1099‐Composite which combines information on interest income, dividend income, mutual fund distributions, and security sales with resulting gain or loss, from your account custodians (e.g., Charles Schwab & Co., Inc.). Over the last several years, the Internal Revenue Service has shifted responsibility for tracking the cost basis of securities (used to determine realized gain and loss on Form‐1099 Composite) to custodians. Prior to this change, Dowling & Yahnke had been providing clients with realized gain loss information to supplement the Form 1099‐ Composite. During the implementation period, Dowling & Yahnke has been reconciling the custodians’ cost basis with our records and reporting discrepancies to clients.

Now that the transition is complete (excluding a very limited number of securities), Dowling & Yahnke will cease providing supplemental reports. Nonetheless, we will continue to work with custodians to ensure they are maintaining accurate cost basis for our clients. We will also continue to be available should you or your tax preparer have any questions regarding the tax information you receive.

As always, we are deeply grateful for the trust our clients have placed in us. We encourage you to call or e‐mail anytime you would like to discuss your portfolio or other financial matters. We wish you the very best in 2018.

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