Trump's tax plan could affect your retirement
The inauguration is just days away and President-elect Donald Trump will soon assume the role of commander-in-chief. Already, Trump has proposed substantial changes to both foreign and domestic policy, including an update to the federal tax code.
If his proposals are accepted, tax brackets would be streamlined from seven to just three: 12, 25 and 33 percent. The federal estate tax would disappear, along with the 3.8 percent Medicare surtax on investment income and the alternative minimum tax. Other tax changes include a cap on itemized deductions and an increase in the amount of the standard deduction.
An analysis of Trump's tax plan conducted by the Urban-Brookings Tax Policy Center found that overall, taxes would decrease by an average of $2,940. While these measures could improve your bottom line in terms of lower taxes, the bigger question to consider is how they could impact your retirement.
Changing tax brackets could mute the benefits of tax-advantaged plans. Traditionally, contributing to tax-advantaged plans has been the logical choice for workers who want to maximize the tax-deferred growth potential of their investments, but they may lose some of their luster if the tax brackets are reshuffled.
"If someone finds themselves in a lower tax bracket after Trump's tax reform, saving in tax-advantaged accounts becomes less beneficial because of the smaller deduction," says Daniel White, founder of Daniel A. White & Associates in Glen Mills, Pennsylvania.
"If an investor in the 39.6 percent tax bracket is maximizing his tax-advantaged accounts, he would get less of a tax benefit by moving into the 33 percent bracket," White says.
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George Elias, a certified public account with Vivid Tax Advisory Services in Des Moines, Iowa, says investors should consider their income and personal preferences when determining how to approach saving in an employer's plan or individual retirement account.
"If you're a high wage earner, then I would do both," Elias says. "If your employer offers matching contributions, then you need to invest to take advantage of the company match."
Jimmy Lee, CEO of Las Vegas-based Wealth Consulting Group, says investors need to keep the long view in focus.
"While income and capital gains taxes may become lower, taking advantage of tax deferral and deductions can be valuable long-term strategies," Lee says.
Tax deferral is particularly important over longer periods of time as tax rates evolve.
Roth investments may become more appropriate for some investors. Mark Jaeger, director of tax development at TaxAct, says some savers may have more incentive going forward to choose a Roth IRA or 401(k) versus a traditional IRA or 401(k), based on how valuable each proves to be from a tax perspective.
"It's always unknown what tax rates will look like in future years. If tax rates decline in 20 years, those who paid tax on their contributions now won't have benefited from that decision," Jaeger says.
If tax rates increase, however the choice to pay today will have been a smart one.
Lower pre-retirement tax rates make saving in a Roth IRA or 401(k) more attractive for many taxpayers, says Robert Westley, a certified financial planner and associate wealth advisor at New York-based Northern Trust.
"The income tax deduction generated by traditional IRA or 401(k) contributions produces less value in a low tax rate environment, especially given that the deferred income will likely be recognized at a higher future tax rate," Westley says.
Westley says investors who anticipate being in a higher tax bracket in the future may want to consider partial Roth conversions to lock in lower tax rates on some of their pre-tax retirement savings.
Joseph Roseman, managing partner of O'Dell, Winkfield, Roseman and Shipp in Charlotte, North Carolina, offers an example to illustrate how important it is for investors to consider all the numbers before pulling the trigger.
"Let's say you have a married couple with $50,000 of Social Security income and $50,000 of IRA income," Roseman says. "In 2016, if they had used the standard deduction and exclusion, they would owe $7,945 in federal income tax."
Using the $30,000 standard deduction Trump has proposed, their tax bill would go down to $6,925, a 12 percent reduction.
"Now assume that same couple has $50,000 of Social Security income, $25,000 of IRA income and $25,000 of Roth IRA income. By contributing to the Roth during their working years, they would have foregone some tax deductions but with this income mix, their federal tax bill would be $1,290," Roseman says.
That's 436 percent less they'd pay in taxes.
The end of the Medicare surtax could be a boon for wealthier investors. Trump's proposal to repeal the 3.8 surtax on investment income could pay off for investors in one of two ways, says Jeffrey Fosselman, a certified financial planner and senior wealth advisor at Relative Value Partners in Northbrook, Illinois.
"By not paying the tax, that amount can be reinvested," Fosselman says. "If viewed as part of the overall return, the reduction of taxes paid on investment earnings means higher returns."
Fosselman says repeal of the tax could also influence the approach investors take in shaping their portfolios. Investors may opt to take advantage of investment opportunities that generate more income, which are generally a more reliable source of return than capital appreciation.
Rebekah Barsch, vice president of planning for Northwestern Mutual, says wealthy investors could get more mileage out of their current investment structure under Trump's plan.
"Currently, wealthier investors may choose to invest in certain places, such as permanent life insurance, retirement accounts, and nonqualified annuities, in part because they avoid the surtax," she says.
Barsch says these types of vehicles will continue to be a critical part of a comprehensive plan if Trump's tax proposals are approved but going forward, investors would get more bang for their buck if the repeal of the surtax puts more dollars in their pocket.
Regardless of your net worth or the size of your portfolio, planning is key, Roseman says.
"If Trump's plan does go through there are going to be a tremendous amount of planning opportunities available," Roseman says.
He advises investors to start preparing for potential tax changes, with an eye on what could happen in future years under the next administration as they put together their retirement savings plans.
Copyright 2016 U.S. News & World Report