The New Tax Law and Retirement Planning
Tax lawyers, accountants and financial planners are all trying to figure out all the changes in the new tax law. The IRS employees have been given less than two weeks between the day President Trump signed the law and the time most of the new provisions went into effect January 1; they too, are scrambling. Now that Congress has approved the most sweeping changes in the tax law in more than three decades, you can bet you’ll be affected. Here are some key changes you need to know about how the new rules affect retirees and retirement planning.
Nearly Doubled Standard Deduction
The new law supersizes the standard deduction – to $12,000 for individuals and $24,000 for married couples who file joint returns in 2018 (up from $6,500 and $13,000). The increase, which does put new limits on some itemized deductions, is expected to lead more than 30 million taxpayers who have itemized in the past to choose the standard deduction instead (because it will reduce their taxable income by more than the total of their deductible expenses).
There’s even more incentive for taxpayers age 65 and older to make the switch because their standard deduction will be even bigger. Like before, those 65 and older or legally blind can add either $1,300 (married) or $1,600 (single) to the basic amount. For a married couple when both husband and wife are 65 or older, the 2018 standard deduction is $26,500.
All the excitement about doubling the standard deduction, however, is somewhat misleading. As a trade-off, the new law eliminates all personal exemptions. The 2018 exemption was expected to be $4,150, so, for a married couple with no children, the $11,000 hike in the standard deduction comes at a cost of $8,300 in lost exemptions. While this will affect your tax bill, it does not affect the standard deduction/itemizing choice.
Much-Reduced State and Local Tax Deductions
The new law sets a $10,000 limit on how much you can deduct for state and local income, sales and/or property taxes for any one year. This could be most painful for retirees with second homes. Previously, property taxes were fully deductible on any number of homes, and there was no dollar limit on write-offs for either state and local income or state and local sales taxes. The new law lumps all so-called SALT (state and local taxes) deductions together and imposes the $10,000 annual limit. This restrictive change, along with the increase in the standard deduction, will likely lead millions of taxpayers to switch from itemizing to claiming the standard deduction.
Deduction for Investment Management Fees Goes Away
Even though one area of government is pushing financial advisers who work with retirement accounts to charge clients set fees rather than commissions, Congress has decided to eliminate the ability to deduct such investment management fees. In the past, such costs could be deducted as a miscellaneous itemized deduction to the extent all of your qualifying miscellaneous expenses (including fees for tax advice and employee business expenses, for example) exceeded 2% of your adjusted gross income. As part of this new tax overhaul, Congress abolished all write-offs subject to the 2% baseline. If you’re paying a management fee for a traditional IRA, consider having it paid from the account itself, which would effectively allow you to pay it with pre-tax money.
401(k)s Spared
There was an outcry of criticism last fall, when it was learned that the House of Representatives was considering severely limiting the amount or pre-tax salary retirement savers could contribute to their 401(k) plans. In the end, though, Congress decided to leave 401(k)s alone, at least for the time being. For 2018, savers under age 50 can contribute up to $18,500 to their 401(k) or similar workplace retirement plan. Older taxpayers can add a $6,000 “catch-up” contribution, bringing their annual limit to $24,500.
“Stretch IRA” Preserved
Early on in the tax-reform debate, it appeared that Congress would put an end to the “stretch IRA,” the rule that allows heirs to spread payouts from an inherited IRA over their lifetime. This could allow for years, or even decades, of continued tax-deferred growth inside the tax shelter. One plan that gained traction on Capitol Hill would have forced heirs to clean out inherited IRAs within five years of the original owner’s death. The accelerated payout would have sped up the IRS’s collection of tax on the distributions. Ultimately, though, the stretch IRA is still available as long as the heir properly titles the inherited account and begins distributions, based on his or her life expectancy, by the end of the year following the original owner’s death.
0% Capital Gains Rate will Continue
The new law retains the favorable tax treatment for long-term capital gains and qualified dividends, imposing rates of 0%, 15%, 20% or 23.8%, depending on your total income. Long-term gains are the profits from the sale of assets owned more than a year. The tax rates on “ordinary” income, such as interest, salary and retirement plan payouts, and short-term gains, range from 10% to 37%.Previously, your capital gains rate depended on your tax bracket. But, with the new changes in the brackets, Congress has instead set income thresholds. For example, for 2018, the 0% rate for long-term gains and qualified dividends will apply for taxpayers with taxable income under about $38,600 on individual returns and about $77,200 on joint returns. The 20% rate applies to investors with taxable income exceeding $479,000 on joint returns and $425,800 on single returns. The 15% rate applies for investors with incomes in between.
The 0% rate often becomes available for retirees after their taxable income falls below the threshold when their paychecks stop.
FIFO Gets the Heave-Ho
For a while, it looked as if Congress would restrict the flexibility investors have to control the tax bill on their profits. Investors who have purchased stock and mutual fund shares at different times and different prices can choose which shares to sell in order to produce the most favorable tax consequences. You can, for example, direct your broker to sell shares with a high tax basis (basically, what you paid for them) to limit the amount of profit you must report to the IRS or, if the shares have fallen in value, to maximize losses to offset other taxable gains. (Your gain or loss is the difference between your basis and the proceeds of the sale.)
This flexibility can be particularly valuable to retirees divesting holdings purchased at different times over decades.
The Senate called for eliminating the option to specifically identify shares and instead impose a first-in-first-out (FIFO) rule that would assume the oldest shares were the first to be sold. Because it’s likely that the older shares have a lower tax basis, this change would have triggered the realization of more profit sooner rather than later.
In the end, though, this idea fell by the wayside. Investors can continue to specifically identify which shares to sell. As in the past, you need to identify the shares to be sold before the sale and get a written confirmation of your directive from the broker or mutual fund.
Do-Overs are Gone
The new law will make it riskier to convert a traditional individual retirement account to a Roth. The old rules allowed retirement savers to reverse such a conversion—and eliminate the tax bill—by “re-characterizing” the conversion by October 15 of the following year. That could make sense if, for example, the Roth account lost money. Re-characterizing in such circumstances allowed savers to avoid paying tax on money that had disappeared. Starting in 2018, such do-overs are no longer allowed. Conversions are now irreversible.
There’s Relief for Some 401(k) Plan Borrowers
The new law gives employees who borrow from their 401(k) plans more time to repay the loan if they become unemployed. Currently, borrowers who leave their jobs are usually required to repay the balance in 60 days to avoid having the outstanding amount treated as a taxable distribution and hit with a 10% penalty if the worker was under age 55. Under the new law, they will have until the due date of their tax return for the year they left the job.
End of Home-Equity Loan Interest Deduction
Taxpayers who use home-equity lines of credit to get around the law’s general prohibition of deducting interest get bad news from tax reform. The new law puts an immediate end on this deduction. Unlike the restriction of the write-off for home mortgage interest—reducing the maximum amount of debt on which interest is deductible from $1 million to $750,000—which applies only to debt incurred after December 14, 2017, the crackdown on home-equity debt applies to old loans as well as new ones.
New Luster for QCDs
The new law retains the right of taxpayers age 70 ½ and older to make contributions directly from their IRAs to qualifying charities. These qualified charitable donations count toward the IRA owners’ required minimum distributions, but the payout doesn’t show up in taxable income. As more and more taxpayers claim the standard deduction rather than itemizing, QCDs stand out as a way to continue to get a tax benefit for charitable giving. Taxpayers who qualify and claim the standard deduction may want to increasingly rely on QCDs.
Custodial Accounts and the Kiddie Tax
If you’re saving for your grandkids, or great grandkids, in custodial accounts, you need to know about changes in the kiddie tax. Under the old law, investment income over a modest amount earned by dependent children under the age of 19 (or 24 if a full-time student) was generally taxed at their parents’ rate, so the tax rate would vary depending on the parents’ income. Starting in 2018, such income will be taxed at the rates that apply to trusts and estates, which are far different than the rates for individuals. The top 37% tax rate in 2018 kicks in at $600,000 for a married couple filing a joint return, for example. That same rate kicks in at $12,500 for trusts and estates – and, now, for the kiddie tax, too. But that doesn’t necessarily mean higher taxes for a child’s income.
Here’s an example: your grandchild has $5,000 of income subject to the kiddie tax and that the parents have taxable income of $150,000. In 2017, applying the parents’ 25% rate to the $5,000 would have cost $1,250. If the old rules still applied, using the parents’ new 22% rate would result in an $1,100 tax on that $5,000 of income. Applying the new trust tax rates produces a kiddie tax bill of $843. The kiddie tax applies to investment income over $2,100 of children under age 19 or, if full-time students, age 24.
New Rules for State 529 College Savings Accounts
If you’re investing in a college fund for your grandchildren, you need to know about changes in tax-favored 529 plans. The new law expands the use of these savings plans by allowing families to spend up to $10,000 a year to cover the costs of K-12 expenses for a private or religious school. The $10,000 cap applies on a per-pupil basis. Previously, tax-free distributions were limited to college costs. Although 529 contributions are not deductible at the federal level, most states offer residents a break for saving in the accounts.
Expanded Medical Expense Deduction
While Congress cracked down on a lot of deductions, and the medical expense write-off was once threatened with complete elimination, in the end the lawmakers actually changed the law so that more taxpayers can benefit from this break. Until the new rules became law, unreimbursed medical expenses were deductible only to the extent that they exceeded 10% of adjusted gross income. The high threshold meant that relatively few taxpayers qualified, although retirees with modest incomes and high medical bills frequently did. The new law reduces the threshold to 7.5% of AGI and the more generous rule applies for both 2017 and 2018. In 2019, the threshold goes back to 10%.
Tax-Free Income from Consulting
Planning to start your own business or do some consulting in the early years of your retirement? If so, one change in the new law could be a real boon.The law slashes the tax rate on regular corporations (sometimes referred to as “C corporations”) from 35% to 21%, starting in 2018. There’s a different kind of relief to individuals who own pass-through entities—such as S corporations, partnerships and LLCs—which pass their income to their owners for tax purposes, as well as sole proprietors who report income on Schedule C of their tax returns. Starting in 2018, many of these taxpayers can deduct 20% of their qualifying income before figuring their tax bill. For a sole proprietor in the 24% bracket, for example, excluding 20% of income from taxation has the same effect of lowering the tax rate to 19.2%.Another way to look at it: If your business qualifies, then 20% of your business income would effectively be tax-free. For many pass-through businesses, the 20% deduction phases out for taxpayers with incomes in excess of $157,500 on an individual return and $315,000 on a joint return.
Higher Estate Tax Exemption
Congress couldn’t bring itself to completely kill the federal estate tax, but lawmakers doubled the amount you can leave heirs tax-free. That means even fewer Americans will ever have to pay this tax. Starting in 2018, the tax won’t apply until an estate exceeds about $11 million. This means a married couple can leave about $22 million tax-free. These amounts will rise each year to keep up with inflation.
The Angel of Death Tax Break
That’s what we call the provision that increases the tax basis of inherited assets to the value on the date the previous owner died. When it appeared that the new law would repeal the estate tax, some observers worried that the step-up rule would be changed or eliminated. In the end, the estate tax was retained, as noted in the previous slide. And, the step-up rule survived. If you inherit stocks, mutual funds, real estate or other assets, your tax basis will, in most cases, be the value on the day your benefactor died. Any appreciation prior to that time is tax free.
Here at TaxProblemSolver.com, we’re available to help you make the most of your retirement – or planning for it, from a tax perspective. If you have any questions, email me at larry@taxproblemsolver.com and I, or one of my Tax Problem Solver Team, will help you with any questions. Let’s make taxes work for us rather than the other way around!
About the Author Larry Heinkel J.D. LL.M
Larry Heinkel is a tax and bankruptcy attorney with more than 38 years experience helping businesses and individuals, solve their state and federal tax problems. Mr. Heinkel has been extremely successful in representing his clients before IRS and DOR, and is known throughout Florida as an expert in tax problem resolution.
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