Journal of Financial Planning: August 2017
Jonathan Guyton, CFP®, is principal of Cornerstone Wealth Advisors Inc., a holistic financial planning and wealth management firm in Edina, Minnesota. He is a researcher, mentor, author, and frequent national speaker on retirement planning and asset distribution strategies.
We’ve been hearing about it since before Day 1 of the Trump administration: tax reform is coming, and in a big way. But the end of 2017 is now closer than its beginning, and although changes to personal income tax laws haven’t yet come to fruition (as of this writing), there’s little doubt that the president and his congressional majority have clear intentions of making that happen.
This time between tax laws can be both confusing and frustrating to those of us counted on to give tax-planning advice. And with the devil always lying in the details, how should retirees respond (or not respond) in this time of uncertainty?
Fortunately, one needn’t know everything before being able to act on anything. Given the present tax code and the stated positions of both the administration as well as House and Senate Republican leaders, we can be rather certain of five key aspects and their related implications.
Personal Income Taxes
The personal income tax code will remain progressive. No one has proposed anything otherwise, such as a single-rate “flat tax.” This, of course, would upend all sorts of tax-planning analytics. Even with fewer than the current seven tax brackets for ordinary income, there will still be multiple brackets with large gaps between them, as is true now; think 13 percent, 25 percent, 33 percent. The size of these gaps and the thresholds for moving into a higher marginal tax bracket are the major unknowns. This has always been key to most pay-now-or-pay-later tax-planning decisions.
This means that most clients for whom Roth IRA conversions currently make sense will continue to find this advantageous. Previously, I’ve described how such planning can be truly beneficial for married couples in retirement when a surviving spouse will find her/himself in a notably higher marginal bracket (see “A Quiet Advocacy: Preparing Clients for a Change in Tax Filing Status,” in the September 2016 issue of the Journal). New tax rates with different bracket thresholds won’t change this, it will only make knowing where the “lines” are important.
Fortunately, the ability to re-characterize will continue to allow for annual fine-tuning based on if, when, and how Congress ultimately acts. About the only situations where this would become inadvisable are client situations where the future marginal rate is the same or lower than today. As good comprehensive financial planners already know, this isn’t new news.
Investment-Related Income
Favorable tax rates will remain for investment-related income like qualified dividends and long-term capital gains. Thus, current asset location strategies that consider both current tax treatment and the future payers of deferred tax liabilities will remain advantageous.
Non-qualified accounts can continue to favor the most tax-efficient equities, traditional IRAs can still hold a disproportionate share of an overall portfolio’s fixed-income assets, and Roth IRAs will still benefit from owning positions with the highest expected long-term returns.
Social Security Benefits
No one is proposing to change the formulas that determine how much, if any, Social Security benefits are taxable. This means that a planner’s thinking and analysis of current claiming strategies for Social Security are still sound. And it will continue to be the case that retirees who were good savers in their 401(k) and similar employer retirement plans will continue to see much of this income (up to 85 percent of it) show up on their tax returns.
Standard Deduction
The standard deduction could get a lot bigger. This is particularly good news for taxpayers who own their homes free-and-clear, live in lower-tax states, or rent. However, it also means many people will have to give more to charity in order to push their itemized deductions above the standard amount available regardless of such things.
An unintended consequence of this is that many taxpayers will find that their taxes aren’t actually lower because of their donation. Or, if the amount by which they exceed the standard deduction pales in comparison to their charitable contributions, they may have a disincentive to give.
There may be no way to avoid this situation entirely, but two approaches can certainly help: (1) retirees old enough to satisfy RMD provisions could direct money to charities via qualified charitable distributions, lowering their taxable income via lowering AGI rather than raising their deduction total. This is available today, but it could become more valuable to far more tax payers than under current tax law (see “How to Use Qualified Charitable Distributions as a Tax-Saving Tool,” in this issue for more on this). And (2) clients of any age could “bunch” their giving into particular calendar years so that a greater amount of their contributions exceed a potentially higher standard deduction.
Affordable Care Act Changes
As of late June, changes related to the Affordable Care Act (ACA) were working their way through the legislative process. Most are reconciliation matters, affecting either the taxes paid by higher-income Americans (earning over $200,000) or the health insurance subsidies for lower-income Americans. However, other changes that individual states may be empowered to enact could increase the risk of not being able to purchase health insurance if you retire early and have less than pristine health.
At the very least, due to freeing insurance companies to charge higher premiums to those nearing Medicare age, health coverage will likely become more expensive due to the ripple effects of these proposed changes.
The bottom line is that almost nothing you would currently advise a client to do under current tax laws would become inadvisable under the various proposed changes. The key is to watch what happens to tax bracket breakpoints—especially because if there are only three brackets, there will be twice as many large jumps between them as today.
In short, one need stop neither the presses nor the planning. Instead keep calm, keep your thinking cap nearby, and carry on!