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WEEKEND INVESTOR
right online bank).
Schwab, which has hoovered up
$220 billion in bank deposits,
earned 61% of its total net reve-
nues in 2019 from the interest it
captured on those balances.
Financial firms can also invest
your money in funds they run
themselves. That way, they capture
fees you would otherwise pay to
somebody else.
By my estimate, 57% of the
$16.5 billion in total assets of the
FlexShares ETFs, managed by an
affiliate of Northern Trust Corp.,
are held by Northern Trust clients.
The firm “adheres to an open-ar-
chitecture investment platform,
applying the same objective and
rigorous selection process to third-
party and proprietary investment
products,” says a spokesman.
Even Vanguard Group, the in-
vestment giant owned by its fund
shareholders, is freezing out other
firms. In its $161 billion Personal
Advisor Services program, whichmanages money for individual cli-
ents, Vanguard won’t recommend
mutual funds or ETFs from any
other companies. Clients aren’t
compelled to sell their non-Van-
guard investments, says a com-
pany spokesman.
The house brand isn’t always
bad, of course. A firm’s own funds
can be cheaper or better than the
alternatives. But investors need to
be on their guard: Under federal
rules, a firm can recommend its
store-brand investments whether
they are ideal or not, so long as
they are a “reasonable” choice.
Finally, complexity pays—for in-
vestment firms, if not their clients.
Take “structured notes.” The re-
turn on these short-term debt in-
struments is pegged—often in
complex ways—to the performance
of other assets, often stocks or
market indexes.
You can lose money, but issu-
ance is booming; in less than one
hour on Thursday, banks and bro-kers filed nine prospectuses with
the Securities and Exchange Com-
mission. Here again, firms often
hawk them to their own clients.
Structured notes are a fee bo-
nanza. Firms rake in upfront
charges of 1% to 4.5%. They earn
more fees for calculating the value
of the notes. They also can make
money by trading against the assets
the structured products are linked
to. There’s generally no market, so
if you need to sell before maturity,
the firm will buy your note at a
price it sets—including a “spread,”
or trading cost to you.
The best questions to ask on the
new Wall Street, then, are these:
What are my financial advisers do-
ing in-house that someone else-
where could do cheaper or more
safely? Where do my brokers put
their own cash? Do my advisers
buy structured products for them-
selves? Above all, should I diver-
sify not just my portfolio—but my
financial advice?The E*Trade
Deal Reveals the
New Rules of the
Investing Game
Brokerages don’t want to be your ‘financial
supermarket.’ They want to grab your cash.
THE INTELLIGENT INVESTOR|JASON ZWEIG
age 18 and many under 24, if they
are full-time students and aren’t
self-supporting. Taxpayers filed
about 370,000 Kiddie Tax forms
and paid $1.1 billion for 2017.
But the Kiddie Tax was complex,
especially if a family had several
children, because it required back-
and-forth between the children’s
tax returns and the parents’.
Sometimes it caused difficult con-
versations about parental income
with older children when they
signed their own returns.
The 2017 overhaul aimed toLet’s recap. Congress passed the
Kiddie Tax in 1986 to prevent
wealthy people from giving income-
producing assets to their children to
take advantage of their lower rates.
The levy imposed income tax on
children’s “unearned” income at
the parents’ tax rate, above a small
exemption. For 2019 and 2020, the
exemption is $2,200. The tax
doesn’t apply to a young person’s
earned income, say from being a
camp counselor.
Over time, the Kiddie Tax ex-
panded so it applies to most undersimplify the Kiddie Tax by taxing
each child’s unearned income at
trust tax rates instead of the par-
ents’ rate. This change did
streamline it, but lawmakers over-
looked its disastrous effects on
low- and middle-income families.
Some of their children have un-
earned income from survivor’s
benefits, taxable financial aid, and
other sources.
The revision spiked these fami-
lies’ Kiddie Taxes because the top
trust-tax rate of 37% kicks in at a
low level, often below $13,000 of
taxable income. Some parents
found their children’s rates far ex-
ceeded their own for 2018.
One widely affected group was
families with children receiving
military survivor’s benefits, often
called Gold-Star families. One
widow of a Navy officer had a top
rate of 12% on her income of less
than $55,000, while her 6-year-old
son had a top rate of 37% on his
survivor’s benefit of about $29,000.
Congress responded by repeal-
ing the Kiddie Tax revision late in
2019 and reinstating prior law for
2020 and beyond.
“The change is a huge relief, be-
cause it put an undue burden on
thousands of our families,” says
Candace Wheeler, policy director
for TAPS, a military survivors’ as-
sistance group.
Lawmakers also allowed filers
to choose either version of the
Kiddie Tax for 2018 and 2019.
Those seeking refunds for 2018
must file amended returns using
Form 1040X.
The Kiddie Tax now provides
opportunities for tax-efficient gifts
that were limited by the revision,
says Tim Steffen, a senior adviser
consultant for Pimco. Here are a
few scenarios.
>>Example 1.A mother and fa-
ther want to help their daughter,
age 24, with professional-school
tuition in 2020. They give her
$50,000 of stock shares acquired
for $15,000 some years ago. The
daughter, who has little other tax-
able income, sells the stock and
has a $35,000 long-term gain.
There’s no Kiddie Tax because
the daughter is 24, and she owes
zero tax on the capital gain be-
cause her taxable income is below
$40,000. Her parents would proba-bly owe at least $5,000 of tax if
they sold the shares.
What about gift tax? Each parent
gets a $15,000 annual exemption for
the daughter’s gifts, and the remain-
ing $20,000 can be deducted from
the parents’ combined lifetime ex-
emptions of $23.16 million.
>>Example 2.A wealthy grand-
father with a 23.8% rate on long-
term capital gains wants to help
his 19-year-old grandson, a full-
time student, pay tuition. He gives
the young man $40,000 of stock
held in a taxable account that was
acquired for $10,000.
The student sells and has a tax-
able gain of $30,000. Most of this
will be taxable at his parents’ capi-
tal-gains rate of 15%. Giving this
stock instead of selling it and giv-
ing cash likely saves nearly $3,000
of tax, says Mr. Steffen.
Again, no gift tax needs to be
paid. There’s a $15,000 annual gift-
tax exemption, and the rest can be
deducted from the grandfather’s
$11.58 million lifetime exemption.
>>Example 3.In 2018, a college
student received $20,000 of finan-
cial aid that was taxable at rates
up to 37%, in addition to non-tax-
able scholarships.
With the law change, the student
can owe the 2018 tax at the par-
ents’ tax rate of 12%, saving nearly
$3,000 of tax, says Mr. Steffen. But
the student must file an amended
return to claim a refund.
Note: under current law, colleges
don’t have to report taxable finan-
cial aid to the Internal Revenue Ser-
vice, and many don’t. Tax specialists
say the agency doesn’t seem to be
enforcing the law in this area.
>>Example 4.An aunt gives her
5-year-old niece shares from a tax-
able account. The stock is worth
$10,000, has a 3% dividend, and
was originally acquired for $2,000.
The child has no other income.
No tax will be due on annual divi-
dends of $300, and no capital-gains
tax will be due unless the stock is
sold. If it is, the starting point for
measuring gain will be $2,000, and
Kiddie Tax could be due.
A final reminder: There’s no in-
come tax, just gift tax, on pres-
ents of cash. Payments of any
amount for tuition or medical
care are free of gift tax if paid di-
rectly to the institution.Time to Go Back to School
On the ‘Kiddie Tax’
Congress has reversed course on an unpopular element of its tax overhaul.
Now, taxpayers face some important choices.
TAX REPORT|LAURA SAUNDERS
Morgan Stanley’s
takeover of E*Trade
Financial Corp. for
$13 billion shows
how drastically
the brokerage
industry’s business
model has changed.
Firms no longer want to offer
investment products from all
sources. Instead, they want to milk
their customers’ cash and manage
all of the assets themselves. Inves-
tors need to understand the rules
of the new game.
For decades, big banks and bro-
kers aspired to become “financial
supermarkets” where consumers
could open bank accounts and buy
stocks and bonds, mutual funds,
insurance and the like.
In the 1980s, Prudential Finan-
cial Inc. sold securities alongside
insurance. American Express Co.
pushed brokerage services and fi-
nancial advice to credit-card cus-
tomers. In the 1990s, Citigroup
Inc. flogged stocks and mutual
funds in its bank branches. Even
the retailer then known as Sears,
Roebuck & Co. sold securities in
its department stores, earning the
nickname “Socks ‘n’ Stocks.”
Some outfits—especially Charles
Schwab Corp. and Fidelity Invest-
ments—made one-stop-shopping
work, managing money themselves
while offering funds from other
firms as well.
But most flailed. Prudential paid
more than $1.5 billion in regula-
tory fines over sales of risky part-
nerships. American Express, Citi-
group and Sears sold their
brokerage and fund units.
Nowadays, the name of the game
isn’t to offer all things from all
sources to all investors. It’s to offer
only what keeps the fees in-house.
Much as the Plains Indians usedCongress made a
big change to the so-
called Kiddie Tax
when it overhauled
the tax code in 2017.
But when lawmakers
learned its terrible
consequences, they switched back.
This zigzag is giving some
taxpayers important choices on
2018 and 2019 tax returns. Others,
such as generous parents or
grandparents, need to relearn how
Kiddie Tax rules will apply for
2020 and beyond.every part of the buffalo, from
flesh to skin to horn to sinew and
hooves, Wall Street excels at creat-
ing strategies with fees that can be
harvested from every component.
In practice, that means investment
firms want to grab as much of your
money as they can and farm out as
little of it as possible.
Wall Street can’t make oodles of
money off your trades anymore;
technology has driven commis-
sions to near zero. And it can’t
make the windfall it once did off
managing portfolios; there, too,
market-tracking index funds and
exchange-traded funds have be-
come cheap as dirt.
Where are the remaining profits
for brokerage firms?They can take your cash and, in-
stead of investing it for your bene-
fit in the highest-yielding money
fund or deposit account, they can
put it in their own bank and pay
you peanuts. Then they lend it out
and keep the profit for themselves.
Morgan Stanley, E*Trade and
Schwab all own banks to which they
route much of their customers’
cash. E*Trade pays its customers
0.01% to 0.25% on their uninvested
cash; Morgan Stanley, 0.03% to
0.2%; Schwab, 0.06% to 0.3%.
Brokerages have been pocketing
2% and up on that money (and you
can do almost as well, if you pull
the cash from your brokerage ac-
count and park it in a certificate of
deposit or savings account at theWall Street can’t make
oodles of money off your
trades anymore. They
have other ways to profit.KIERSTEN ESSENPREIS
PHOTO ILLUSTRATION BY EMIL LENDOF/THE WALL STREET JOURNAL; PHOTOS: ISTOCK