Who Puts Investors Interest First

September 19, 2019Evergreen Q3 2019, News

Woodstock Quarterly Newsletter / Q3 2019

There is current interest in the effect of the new tax law changes on investment fees. Before discussing deductibility, investment fees have always had to be justified. For assets managed at a firm like Woodstock, the ownership of individual equities, not in a pooled investment structure, allows the investment manager to use asset allocation, tax considerations and turnover, in other words use the levers available, to effectively save as much as the management fee might be.

Best estimates are that being able to use the levers and use them effectively adds 1% to 3% per year to an account, however occurring intermittently over the years.[1] In pooled investments such as mutual funds, there are no levers to pull and the published fee schedule may leave out 12(b)-1 fees, the pooled sales charges. For a Woodstock type account the management fee can be effectively wiped out by manager initiated savings. The client benefits from the full upside over the years. A client notices this by watching the overall value of their account go up by more than they might have thought or go down by less, depending on the market and their withdrawals.

The new tax law has ended the deductibility of investment fees for taxable accounts. It’s a loss for every taxable account, but especially for pooled investment vehicles, which had no way to offset the fee to begin with.

The other major change is the Alternative Minimum Tax (AMT). Woodstock clients tended to be thrown into the old AMT because deductions for state and local taxes, personal exemptions and miscellaneous expenses were added back to income and taxed at 28%. If bigger than the regular tax, then AMT was due. Under the new cap on state and local taxes, is only $10,000 is allowed, so only $10,000 is added back. Together with the elimination of adding back other deductions this means that the estimate of AMT filers who earned $500,000 or less for 2018 is about 120,000 taxpayers down from 4 million in 2017.[2]

When talking about income inequality or income equality the way income is measured is important. The measurement of “earned income” is according to the U.S. Census Bureau’s income distribution tables. “Spendable income” subtracts federal, state and local taxes from earned income and adds back “Medicaid, food stamps, the earned income tax credit and 85 other federal payments and services” (totaling almost $1 trillion in 2013), plus the equivalent in state and local programs and services.[3] Income statistics tend to separate Americans into quintiles. The effect of using spendable income instead of earned income is to change the percent of income allocated to the bottom three quintiles from 2.2%, 7.0% and 12.6% respectively to 12.9%, 13.9% and 15.4% for 2013, making the bottom 60% of Americans almost equivalent in spendable income in spite of them being called the bottom, lower middle and middle-income respectively. The biggest change is to the top quintile which drops from 57.7% of earned income to 39.3% of spendable income. From the bottom quintile to top quintile the “gap” is only 3 times when looking at spendable income, as the authors point out.

If you or any of your other advisors have questions about the issues raised here, please contact your investment manager or one of us.

William H. Darling, CPA – Chairman & President
Jeanne M. FitzGerald, CPA – Tax Manager

[1]  Vanguard research, 2016. Ask your portfolio manager for exact reference.
[2]  WSJ 5/19-20/201
[3] WSJ 6/25/18