Since President Trump and Congressional Republican leadership unveiled their new tax plan, media coverage has been intense and your clients are undoubtedly wondering how it will impact them.
For many of them, there’s plenty of good in the plan; for other clients, it will be a bad deal; and frankly, there are aspects of the proposal that, regardless of income, political affiliation and other factors, are downright ugly. Let’s review some of those elements in detail.
THE UGLY
Blatantly misleading elements – Nowhere is this more apparent than in the proposal’s explanation of the zero tax bracket. This section of the proposal says that “the framework simplifies the tax code and provides tax relief by roughly doubling the standard deduction” to $24,000 for married couples. On the surface, this would represent a near doubling of the current $12,700 standard deduction that applies to married couples. However, just a bit further within the same section, the bloom begins to fall off of the rose.
The proposal goes on to say that “to simplify the tax rules, the additional standard deduction and personal exemptions for the taxpayer and spouse would be consolidated” into the new $24,000 standard deduction. There should be little doubt as to the proposal’s claim of simplification here, but when the proposal says it will consolidate the additional standard deductions and personal exemptions, what it really means is that it will eliminate them. It’s just that the optics of eliminating tax breaks doesn’t play well. “Consolidation,” on the other hand, doesn’t sound so bad.
When taking into consideration the consolidation of tax benefits, the proposal's new standard deduction begins to look far less generous. Consider the following examples, which illustrate the differences between the amount of income that would fall into the zero tax bracket under the current system vs. the new proposal:
Scenario #1: Married Couple, Each Age 66 | ||
Current | Proposed | |
| Standard Deduction | $ 12,700 | $ 24,000 |
| Add’l Standard Deduction (Spouse 1) | $ 1,250 | N/A |
| Add’l Standard Deduction (Spouse 2) | $ 1,250 | N/A |
| Exemptions (Spouse 1) | $ 4,050 | N/A |
| Exemptions (Spouse 2) | $ 4,050 | N/A |
| Total Income in 'Zero Tax Bracket' | $ 23,300 | $ 24,000 |
| Total Increase in 'Zero Tax Bracket' | 3% | |
| Scenario #2: Married Couple, Each Age 60 | ||
Current | Proposed | |
| Standard Deduction | $ 12,700 | $ 24,000 |
| Exemptions (Spouse 1) | $ 4,050 | N/A |
| Exemptions (Spouse 2) | $ 4,050 | N/A |
| Total Income in 'Zero Tax Bracket' | $ 20,800 | $ 24,000 |
| Total Increase in 'Zero Tax Bracket' | 15.4% |
In scenario #1, a married couple who are each 66 can have income of $23,300 in 2017 that would fall into the zero tax bracket. That’s not as much as the $24,000 standard deduction proposed for next year, but it’s a far cry from doubling. In fact, it's an increase of just 3%!
Even if you back out the additional standard deductions that aren’t generally available to younger couples, as illustrated in scenario #2, it still only amounts to a roughly 15% increase in the zero tax bracket. And if you happen to have an older client (66+) who is blind, their zero tax bracket would actually be worse under the new plan. All of this makes the “doubling” language very misleading; a tax policy sleight of hand. Great for headlines, but not even close to what people will feel in their wallets.
Moreover, questions are lingering. Since the proposal was formally released, there have been dribs and drabs of additional information making its way into the public domain, but there are still an enormous amount of unanswered questions. At what income levels do the different tax brackets take effect? Will the mortgage interest deduction be further limited? Will the elimination of the estate tax also see the return of carryover basis? I don’t think anyone was expecting a final draft of legislation to be made available for review, but for an administration that repeatedly assured us that we’d already have tax reform completed by this time, the proposal seems rather lacking in specifics.
THE BAD
Blue-state clients will be seeing red – In what should come as little surprise, the new proposal calls for the elimination of the itemized deduction for state and local income taxes. The elimination of this tax break, which costs the federal government in excess of $100 billion annually, disproportionately impacts clients living in states with high state income tax rates. These states tend to lean heavily democratic, providing Republicans, who currently control both Houses of Congress and the White House, little incentive to retain the tax break.
Luckily, since I penned this piece on Oct. 3,
That's important because the loss of this deduction could significantly impact some clients’ tax bills. In New York, for instance, the average deduction for state and local income taxes is north of $7,500. For a client in the 25% bracket, the loss of such a deduction would result in an increase in taxes of nearly $2,000!
Upper-middle-class clients could be harmed by tax bracket consolidation – Mass affluent clients make up a large portion of many advisors’ books of business. Under the new proposal, many of these clients could be negatively impacted by a proposed reduction in the number of tax brackets, from the seven we have today, to just three. As noted earlier, the precise income levels at which the various brackets apply has not yet been decided, but President Trump has previously floated $225,000 as a potential cap for a 25% tax bracket for joint filers.
If the $225,000 figure sticks, it could hurt married clients with income in the roughly $300,000 to $400,000 range. Today, such clients pay “just” a 33% rate on that income, but with the elimination of the 33% bracket, that income could become subject to the higher 35% rate.
THE GOOD
The elimination of the AMT – The alternative minimum tax has, for many years, failed to serve its original intention of preventing perceived tax abuse by the ultra-wealthy. Instead, it’s become an albatross around the necks of nearly 5 million taxpaying households. An overly complicated mess that, frankly, even many tax professionals can’t explain, it has needed to go for some time now. Few people will mourn the death of the AMT if it comes to pass.
Retirement tax breaks to stay in place – In recent weeks, there has been a lot of speculation that the Republican tax reform proposal would include a so-called “Rothification” provision, eliminating the tax break for contributions to 401(k)s and similar types of retirement accounts. Clearly, such a change would have wide-ranging impacts for many clients. The proposed framework, however, should alleviate concerns regarding this matter, as it calls for the retention of “tax benefits that encourage work, higher education and retirement security.” It appears that Rothification is off the table… at least for now.
Businesses and business owners will get a shot in the arm – The new proposal calls for a mega-reduction of the top corporate tax rate from a top rate of 35% to just 20%. The proposal also calls for an end to the U.S.’s worldwide tax structure, to a territorial system. It calls for a transition rule that would treat certain amounts, previously earned and held overseas, as repatriated amounts subject to a tax.
Large businesses would not be the only ones to benefit from the proposed changes. Small business income, such as income from sole proprietorships, partnerships, and S-corporations would be taxable at a maximum rate of 25%. Today, successful business owners pay as much as 39.6% on the same income. Such a change could spur entrepreneurial spirits, as the rewards for creating a successful business are enhanced.
Of course, such a change would also open a Pandora’s Box of possibilities for high-income clients and their advisors to find creative ways to turn non-business income into business income. To be fair, the proposal does call for the formulation of rules to prevent this, but let’s face it, wealthy people and/or high income earners will hire lawyers, CPAs and other professionals to find loopholes and ways around rules. And if the tax code really gets as simple as the proposal implies, there will be plenty of un- or under-employed professionals looking for new ways to generate business!
Ding, dong. The death tax is dead – Depending on your point of view, this is either appropriately placed in the “good” category, or it should be moved into the “ugly” group. In either case, however, this proposal should come as no surprise. From day one, it’s been a virtual certainty that the Republican proposal for tax reform would call for an elimination of the estate (death) tax. The only real question at this point, which the proposal does not address, is whether carryover basis would be reinstituted, or if the step-up in basis rules would persist under the new estate tax-less regime. The latter of these two options would potentially allow large swaths of wealth from ever being taxed.
Along with the estate tax, the proposal also calls for a repeal of the generation skipping transfer tax. There is no mention of the gift tax, however, but it’s probably safe to assume that a gift tax of some sort would remain in place to prevent abusive transfers aimed at minimizing income tax.
To be sure, if tax reform come to fruition, it’s likely that much of the newly-released Republican proposal will have changed. Some of the provisions will likely be dropped, while others will be added. Others will simply be tweaked. The proposal, though, is a starting point. It’s a wish list that signals the intentions of the President and Republican leadership. There’s no need to rush to amend clients’ plans at this point, but clearly, advisors must continue to closely watch this issue so that they can properly guide their clients if and when it becomes necessary.
