January 13, 2017
Understanding the 2017 Income Tax Reform: An In-Depth Look at the President-Elect’s and Paul Ryan’s Proposals and How They Affect You
The Republicans swept the polling stations in 2016 by taking control of the House, Senate, and the presidency. One of the primary items on the agenda is tax reform. Despite the Republicans taking control of Congress, tax reform may be no easy feat as the Democrats may still cause problems for them through a filibuster in the Senate. In spite of this, we believe there is a high likelihood of tax reform. The Democrats may come across the aisle to negotiate or individual tax reform can also pass through the use of budget reconciliation. According to the Byrd Rule, this might mean that the tax reform could sunset after 10 years. Speaker Paul Ryan (R-Wis.) wants a “leaner, meaner” tax code while Donald Trump promises “the biggest tax revolution since Reagan”. They disagree on some of the details, but they both want to take us down to three tax brackets, keep preferential tax treatment of capital gains and dividends, reduce or eliminate tax deductions, and get rid of the dreaded alternative minimum tax, which potentially is the most exciting piece. In my last post, I broke down some of our year-end tax strategies with the expectations of tax reform. Today, I’m going to take a deep dive into the Trump and Ryan proposals to understand how they can affect you.
Income Tax Brackets
Both Paul Ryan and President-elect Donald Trump emphasize that simplicity is one of the main goals of tax reform. One of the first steps includes decreasing the number of marginal brackets from seven to three. Trump’s current proposal is mostly in line with the House GOP plan.
The marginal bracket for married couples is proposed to be 12% for incomes of up to $75,000, 25% for incomes between $75,000 and $225, 000, and 33% thereafter. For married filers, the thresholds for the beginning of the 25% and 33% brackets are projected to be very similar to the 2017 tax brackets. This gives most filers an overall reduction in total tax no matter where their income ends up. See the charts below from Michael Kites’ blog post on Understanding The 2017 Income Tax Reform.
However, this is not the case for individual filers. Income thresholds for individual filers are proposed to be half of the thresholds set for married filers. The current individual threshold for the 33% bracket is expected to be around $191,500 in 2017. The 33% bracket for individuals would begin at $112,500 under the new proposal. For single filers who earn between $113K and $191K, this would notably increase the aggregate tax they must pay. This tax rate increase for individuals may be an attempt to fix the marriage penalty, which affects married couples that both make similar income earnings and end up paying taxes that exceed the amount of taxes they would have paid had they remained single.
Investment Income Tax Rates
Unlike the tax brackets, there is a bigger difference for the investment income tax proposals between the Trump and House GOP plans. Trump’s strategy is to keep the three current rates of 0%, 15%, and 20%, and correspond the rates to the three marginal tax brackets of 12%, 25%, and 33%. He would also like to repeal the 3.8% Medicare surtax. With Trump’s plan, many filers will not see a difference on their investment income tax. The problem is for married filers who earn between $233K and $416K, and single filers who earn between $116,500 and $418K. For these filers, capital gains and qualified dividend tax rates will go up 1.2%, but there is a flipside. Married couples who earn more than $470,000 will see a decrease in capital gains and qualified dividend tax rates of 3.8% as the Medicare surtax is removed, which will also apply to single filers who earn $418,000 or more.
In comparison, Paul Ryan’s plan allows individuals to exclude 50% of their investment income, but it will tax their investment income at ordinary rates. This includes capital gains, qualified dividends, and even interest income! If interest income is taxed at preferential rates, it can be a huge savings for many investors. Potentially, it can make taxable bonds more attractive. By taxing only 50% of investment income, this effectively means that investment income will be taxed at half the ordinary income tax rates, which will give us rates of 6.5%, 12.5%, and 16.5%. Like Trump’s proposal, the House GOP plan would also repeal the 3.8% Medicare surtax. With the House GOP plan, the tax on investment income would generally go down for all income earners, except for income earners with aggregate income under$75,000. Previously, individuals who earn less than $75,000 could realize capital gains and dividends at a 0% tax rate, now they will pay a 6.5% tax rate.
Future Tax Deductions
Trump and Ryan disagree even more on how they want to handle tax deductions. Trump’s original proposal would keep all itemized deductions but create caps much similar to the Pease limitation. Trump’s current proposal caps itemized deductions at $200,000 for married couples or $100,000 for individuals. Trump is also planning on consolidating the standard deduction and exemption to one single large deduction of $15,000 for individuals and $30,000 for married couples.
In comparison, the House GOP plan would keep the mortgage, charity, retirement, and education savings deductions, but practically eliminate all other deductions. The plan is in line with Ryan’s goal to simplify the tax code and allow filers to file their tax return on a postcard. Like Trump, the House GOP plan is proposing to consolidate the standard deduction and exemption to one single larger deduction. In this case, $12,000 for individuals, $18,000 for individuals with a child, and $24,000 for married couples.
Both plans would repeal the alternative minimum tax, which would also dramatically simplify tax filings for many high-income earners.
Feasibility of Reform
To reiterate my statement earlier, we believe there is a high likelihood of some type of tax reform that will pass in 2017. One problem with Trump’s proposal is it is projected to substantially increase the deficit, even with “dynamic scoring.” However, Trump’s proposal lowers the amount of marginal rates from seven to three, but it keeps most deductions and exemptions. It even adds deductions like childcare tax credit, all while adjusting the cap on deductions. It is a fair argument when critics point out that Trump’s plan does not truly simplify personal income tax. On the flipside, the House GOP plan proposes to remove the vast majority of deductions and exemptions and allow filers to file their taxes on a postcard. This could dramatically reform and simply the tax code. The House Republicans’ goal is to keep tax reforms revenue neutral. Of course, there is a lot up in the air about how the two proposals will come together.
In future posts, we will update you as tax reform progresses and keep you in the loop about what tax planning strategies are worth considering.
Willis Johnson & Associates is a registered investment advisor. Although this information has been gathered from sources believed to be reliable, it cannot be guaranteed. This material is intended for informational purposes only and should not be construed or acted upon as individualized investment advice. Willis Johnson & Associates nor its investment advisor registered representatives, offer tax or legal advice. Federal tax laws are complex and subject to change. As with all matters of a tax or legal nature, you should consult with your tax or legal counsel for advice. This material may contain forward looking statements and projections. There are no guarantees that these outcomes will come to pass.
Nick Johnson, CFA®, CFP®
Nick Johnson believes that financial planning is more than numbers on a balance sheet and a standardized process. People are unique and should be treated as such.
As Vice President and Wealth Manager at Willis Johnson & Associates, his goal is to really get to know his clients, all the while providing a proactive approach to comprehensive wealth management.