The reforms President Trump signed into law in December may be the broadest tax rewrite enacted in decades, but the changes are subtle when it comes to your retirement savings. The immediate impact varies from person to person: Some will benefit from lower rates, others will miss key deductions, and some will simply do whatever their TurboTax software tells them to do.
Of course, the key to successful retirement planning is to look at the long term, not just the coming year's tax savings. With that in mind, here are six moves to consider making in preparation for what tax reform will bring to your 2018 bill and beyond:
1. Transfer investments out of taxable accounts.
The new lower tax rates won't last forever—for you. While they are permanent for corporations, for individual taxpayers, they're scheduled to expire in 2025. This gives you a seven-year window to take action and lower your overall lifetime tax liability.
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One way to do that: If you're over 59½ and can withdraw money from your IRA or 401(k) without paying a penalty, you can tap those accounts, pay a lower tax now and eliminate higher taxes in the future.
That may sound like a drastic move. Most people are reluctant to pull money from their retirement accounts unless they really need income to support themselves. Financial experts frequently warn about the daunting tax bill investors will face when they start withdrawing funds from their tax-deferred retirement plans. An investor in his or her early 60s with $1 million in retirement accounts may be looking at taxes exceeding $2 million on their required distributions from age 70 to 90.
That's why you must be proactive and take advantage of this incredible opportunity the new code offers some retirees. For example, if you're a married couple filing jointly, and your adjusted gross income (AGI) is $300,000 in 2018, your effective tax rate is 19.7% while under the old code, it was 24.4%. That's substantially lower, and using this strategy can easily amount to hundreds of thousands of dollars of tax savings over a 30-year retirement. So it may make sense to aggressively withdraw funds over the next seven years while keeping your total income at or below the 24% tax bracket (which is $157,500 for individuals and $315,000 for married filers). Pay the taxes on it now, and move the money into a Roth account for tax-free growth and income, or another appropriate investment.
Plus, this strategy will significantly reduce or eliminate the tax burden on family and beneficiaries. When you pass away, money in your traditional 401(k)s and IRAs is subject to ordinary income taxes. But if the money is outside of such accounts and invested in the stock market, your heirs get it income-tax-free and enjoy the benefit of a stepped-up basis at death.
2. Run the numbers on your Roth conversions—again.
If you do a Roth conversion, you can't change your mind anymore. The standard practice used to be to do a Roth conversion early in the year, moving funds from pre-tax IRAs to Roth IRAs for tax-free growth and distributions. These conversions are subject to ordinary income tax. If you changed your mind by October 15—say the market didn't do well or if your income pushed you into a higher than expected tax bracket – you could undo or "recharacterize" it. Under the new law, however, that won't be allowed. That doesn't mean you shouldn't do a conversion. You just need to be extra careful and run the numbers first.
3. Probably skip itemizing.
One of the biggest changes to the tax code is that the standard deduction is much higher than under the previous rules. Plus, those age 65 and older have an additional amount of $1,600 for single filers and $2,500 for married filers.
For a married couple filing jointly, the new tax system will give you a total standard deduction of $24,000, plus an additional deduction of $2,600 if you're both over 65, for a total deduction of $26,600. For single filers over 65, the standard deduction is $13,600. Because of this, you need to scrutinize every expense you've deducted in past years and calculate whether itemizing is still worth it for you. Many retirees will be better off with the standard deduction.
4. Analyze your debt.
It may be time to pay off your home loan or your equity line of credit. The old $1 million mortgage interest deduction cap still applies to homeowners who took out mortgages on or before Dec. 15, 2017. Any new mortgage is now capped at $750,000 as far as tax deductibility. The new rules limit the total deduction for state and local income taxes to $10,000. Also, the old deduction for interest paid on a home equity line of credit or loan is off the table for everybody until 2025—unless you use the proceeds to buy, build or improve a main home or second home, in which case, it's still deductible. Because of this, the tax incentive to keep a mortgage or HELOC on the books is limited.
5. Get your medical procedures done.
The threshold for deducting medical expenses is lower. Under the new law, you're allowed to deduct medical expenses that exceed 7.5% of your AGI. (The old threshold was 10%.) If you've been close to making the cut in the past, it may be worth doing the math and bunching up medical expenses in the next couple of years. The lower threshold applies through 2019; in 2020, the 10% limit kicks back in.
6. Adjust your strategy for giving.
Since many people will want to take advantage the higher standard deduction rather than itemize, they may no longer be inclined to make charitable contributions for tax purposes. (If you do itemize, however, your contributions are still deductible.)
If you're older than 70½, though, you have an alternative. You can still transfer up to $100,000 per year from your traditional IRA to charity and count it as your required minimum distribution. If you follow the rules for Qualified Charitable Distribution, it won't be taxable. (But it doesn't count as a tax-free transfer if you withdraw the money first and then donate it.)
Bonus Tax Tip
While not related to the tax changes, it is worth mentioning one last item. To the extent you can, hold your equity-based investments in after-tax accounts. This allows you to get the benefit of lower capital gains tax rates when you sell the positions to generate income. All investments in retirement accounts are taxed as ordinary income when the money comes out. It may seem counterintuitive, but holding more conservative investments like bonds and annuities in your retirement accounts can help lower your taxes paid over time.
Bottom Line
There's still a lot of confusion out there regarding this major tax reform and its ultimate impact. Clearly, it's a complicated topic. If you're unsure about how the changes will affect you, contact your CPA, tax attorney or financial adviser for information and guidance.
Kim Franke-Folstad contributed to this article.
Advisory services offered through J.W. Cole Advisors Inc. (JWCA). JWCA and Arola Associates Inc. are unaffiliated entities.
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