Update Dec 2, 2017: The Senate passed their tax proposal early this morning. It is anticipated that the reconciliation between the Senate and House versions of the bill will go smoothly and it will be signed by the President soon. As soon as the final details emerge we will either update this article or create a new one, so that you can see how tax reform might affect your retirement.
November 23, 2017 — Recently we had some Comments made to other posts that touched on how the proposed tax bills approved by the House and being considered by the Senate might affect retirees. While the bills and different how they might be reconciled in the end is very fluid, it is worth considering how they impact your retirement. Just about everyone agrees that the concept of simplifying our overly complex tax code is a good thing in principle. But it also certain that any tax reform always produces winners and losers. In this article we will give our opinions on how different groups of retirees would fare on tax reform. Let us hope for your sake you are among the winners!
Tax Reform and Roth Conversions
Here is the Comment by Peder: “If the tax reform/cut/whatever gets through and they raise the 25% bracket all the way to $200K, I’m seriously going to consider converting my IRA to a Roth before I need to make RMDs (Required Minimum Distributions). Would be nice not to need to waste my brainpower managing their cut anymore!” Louise then responded wondering if there was an article explaining the tax reform/cut on how it will affect RMD’s.
Regular 401(k)s vs. Roth IRAs
Peder’s comment is interesting. Here is a little background. Money you have in your 401(k)/IRAs has to start coming out in the form of Required Minimum Distributions (RMDs) the year you turn 70 1/2. The percent you have to take out starts small (a little over 3%) and gets higher as you get older. All of that money is taxable when it comes out, in exchange for your contributions being tax deductible, and because your earnings over time were not taxed. Roth IRAs are different. These contributions to your retirement are made after tax, and are not deductible. But their advantage is that you are not required to take any money out of these accounts, and your contributions and earnings are not taxable (if you wait until retirement age).
Many financial advisors urge their clients to convert some or all of their 401 (k) accounts to Roths, if they can meet the requirements. The reason is that Roth contributions and earnings are not taxed when they come back out, and there are no RMDs. The kicker is what Peder was speculating on – if you can convert your regular 401(k)s when your tax rate is lower, it makes a big difference. The amount you convert, combined with your other earnings, could throw you into a high tax bracket. But, if tax reform lowers the rate you have to pay, the conversion might be a better deal.
Fairly small bracket changes coming
Compared to the possible 15% tax cut for corporations, the tax bracket changes for individuals proposed by the House and Senate are not earthshaking. At the luckiest you might see a 2 or 3% decrease in your tax rate, although taxpayers with a current 33% rate might actually go up to 35%. The House bill reduces 10 brackets to 4, while the Senate version reduces it to 7. Income thresholds for each bracket also change; where you fall into one of those brackets makes a difference. There might be many good reasons to convert to a Roth, but from what we have seen so far there is no groundbreaking news in the current tax reform to change your current strategy. That being said, since taxes on individuals are set to actually increase in 10 years, maybe this could be the best time you are going to get.
What to do
Wait and see, that is the best answer we can provide now. Nothing is final and lots could change, assuming the bills even pass. Even when you do see the final brackets and tax rates, you won’t know if converting is a good idea or not until you know exactly what your other income for the year will be. Since we are not tax experts, we look forward to comments from knowledgeable people on this topic.
Other winners and losers
Recognizing again that the current tax bills might never actually become law, or that if they do they might be quite different than they are now, here are some thoughts on how the current proposals produce winners and losers among the retirement age population.
Where you live
The state in which you live has a lot to do with how the current tax reform proposals affect you. If you live in a red state with low property taxes and state income taxes, tax reform as it proposed is OK, maybe even good. However if you are from a high tax blue state like California, New Jersey, New York, or Pennsylvania – you could get hit hard and be part of the loser group. That’s because the bills propose eliminating state income taxes as a deduction, and either eliminating or greatly reducing property tax exemptions.
Do you have a big mortgage?
Normally retirees don’t have a big mortgage. But if you do, one of the proposals is to eliminate the deduction on home mortgages greater than $500,000. That could hurt and put you in the loser group.
Real estate dislocations
Many trade groups are opposed to the proposed tax reform bills because they think it is going to hurt the real estate market. Here is what the National Association of Realtors says about it on their website: “The Tax Cut and Jobs Act threatens homeowners with a loss of tax incentives and a reduction in home values. Eliminating the state and local property tax deduction and changes to the capital gains exemption will increase taxes now and when a home is sold.” The net effect might be to reduce home values, particularly in high tax states.
The Senate version of tax reform would eliminate the individual mandate part of the Affordable Care Act (Obamacare). While this would help younger people who feel they don’t need health insurance, this provision would be a crippling blow for Americans over 50 who have to buy their own insurance and make more than $48,000/year. Insurance rates will go up without healthy young people included in the mix, and those who can’t qualify for a subsidy will either be priced out of the market, or devote a large portion of their disposable income to health insurance. It is estimated this provision would cause 13 million people to become uninsured, many of those would be older Americans who pay for health insurance and don’t qualify for subsidies.
According to the Congressional Budget Office (CBO) the proposed tax reform bill could force $25 billion in cuts to Medicare for 2018. If you are part of Medicare, this puts you in the losers column.
Do you have a lot of medical expenses?
The AARP estimates that 1.2 million Americans over 65 could see their taxes actually go up in 2018 with tax reform. That is because of the elimination of medical expense deductions, which a surprising number of older Americans take, and the deduction for being over 65.
Have an estate worth more than $11 million (couple)?
The proposed elimination of the estate tax would affect an estimated 5,500 estates a year, or about 2 out of every 1,000 Americans who die. If you are one of those or one of the 80 family owned farms or businesses a year that would now escape the estate tax, you are a winner (well at least your heirs are!).
Do you own a lot of stock or are you very wealthy?
You might be a winner, because the big proposed cuts to corporations will probably mean stock prices will go up along with dividends. And they are likely to stay high, because unlike the proposed tax cuts for individuals, which will actually increase in 10 years, the corporate tax cuts would be permanent. Tax cuts for the very wealthy are very generous; not so much for those in the middle or the bottom.
Who knows if tax reform will pass or not. Republicans desperately need a win, and that could propel one of these bills over the finish line. Viewed from the lens of someone over 65, tax reform as currently proposed doesn’t look like a good thing to us. However you see it, it is time to let your elected representatives know you feel.