October 2017 Newsletter to Clients

Enjoy this month’s newsletter where we share an initial analysis about President Trump’s tax reform proposal and an update on BlackRock floating rate income funds.

Tax Reform: It is our job at Moneywatch Advisors to analyze policy changes, assess the impact on our clients and help you change strategies, if warranted. So, we’ve been following the President’s tax proposal and here is our initial assessment of the framework released so far.

The first principle of the tax proposal framework is to simplify the tax code – which is unnecessarily complicated. As part of this effort to simplify, the framework decreases the number of tax brackets – the percentage of tax one pays – from seven to three. They are proposed as 12%, 25% and 35%. What we don’t know yet is what amount of taxable income fits into each bracket. So, let’s examine how the proposal compares to current tax law.

As an example, let’s imagine a married couple who earn a combined $125,000 in salary and each contribute 5% pre-tax to their employer’s retirement plan. For simplicity sake, we’ll ignore other deductions like their pre-tax cost of their employer’s health insurance plan, and call their Adjusted Gross Income (AGI) $118,750. (Gross income minus their retirement contributions) They have two children.

Under current law the couple has a choice between subtracting the standard deduction of $12,700 from their AGI, or itemizing deductions. As you can see below, their itemized deductions are more than their standard deduction, so they obviously deduct the larger amount:

• Mortgage interest deduction – $5,578 (Interest paid on their $200,000 house where they still owe $150,000 at 3.75% interest)
• State and Local Income tax deduction – $9,797
• Property tax on their home – $2,000
• Charitable contributions – $1,000
• Total: $18,375 (clearly more than the standard deduction of $12,700)

In addition to their itemized deductions, they are also allowed to deduct $4,050 each as personal exemptions plus dependent exemptions for each of the kids, for a total of $16,200.

Finally, their AGI of $118,750 minus their itemized deductions of $18,375 minus their personal exemptions of $16,200 equals Taxable Income of $84,175. Again, we don’t know yet what tax rate to apply to this number, and that could make a huge difference between the couple’s actual tax bill under current law and the proposal.

Under the President’s proposal the couple’s tax computation does become simpler: Although mortgage interest and charitable contributions would still be allowable as itemized deductions, state and local income tax and property tax are not allowed. As a result, they find their itemized deductions are lower than the proposed new standard deduction of $24,000, so they choose to use the new, standard deduction. And, the personal and dependent exemptions have been rolled into the proposed standard deduction, so those would not be deductible.

Their AGI of $118,750 minus the standard deduction of $24,000 equals Taxable Income of $94,750. A much simpler calculation but a larger amount of taxable income, under this example.

Conclusion: There are currently more questions than answers as this proposal has not wound its way through the legislative process for open discussion yet, but taxable income for our sample couple is higher under the proposal than under current law – by $10,575. Further, we don’t know the impact on what they will actually owe because the applicable tax rates haven’t been released as yet. Their actual tax bill could be lower, we don’t know. In addition, they may benefit from a higher Child Tax Credit beyond the current $1,000, as the framework refers this matter to Congress to work out the details. The framework also doesn’t mention capital gains rates or the treatment of dividends. These can be significant issues for those who have large amounts in taxable investment accounts.

While there is much left to be decided, those of us in states like Kentucky need to watch closely if the elimination of the deduction of state and local income tax as well as state property tax becomes law. For all states with personal income tax, the elimination of these deductions can be significant. As more details become clear, we will update this assessment.

BlackRock: The BlackRock Floating Rate bank loans funds (BGT $14.11 & FRA $14.36) have been rising in price for a couple of reasons. First, short term interest rates are going up and this translates into higher cash flow from the bank loans owned by these funds. For those of us who owned shares for over one year, we will recall BGT paid an extra dividend of 12.5 cents per share and FRA 14.29 cents per share at the end of last year. Second, the Board of Directors of BGT & FRA announced authorization of an open market share repurchase program of up to five percent of the outstanding shares at a discount from the net asset value. At this writing BGT is selling well below its net asset value of $14.44 and FRA is priced at $14.36 while its liquidation value (net asset value) is $14.95.

The Federal Reserve Board chairwoman recently announced the Board’s expectation of three more one-quarter point interest rate increases over the next twelve months. These increases will certainly translate into a higher cash flow for our floating rate bank loan fund holdings. It should not be long before we see increases in the regularly scheduled monthly distributions. We suspect that the extra cash accumulating in the Fund’s coffers is being wisely used for the Share Repurchase program which likewise will lead to a higher distribution rate.

Thank you for your continuing confidence.

Past performance is no guarantee of future results. The opinions expressed are those of Moneywatch Advisors, Inc. and are no guarantee of the future performance of any particular fund. This information is for educational purposes only and is not intended as investment advice. Please consult your financial advisor for more detailed information or for advice regarding your individual situation.​​