Tax reform. We all have questions about what to expect. We’ve all wondered what it will entail, and how it will affect us. Finally, we have some answers.
The Republican tax plan has been unveiled. Republicans hope President Trump will sign the bill into law by Christmas. Democrats think otherwise. Politics aside, let’s focus on the proposed plan.
Here’s my reading of the GOP proposal.
Generally speaking, there is something in the tax plan for everyone. On the surface, it does look like some families could see an overall tax cut of between $500 and $2000 per year. Included is a doubling of the standard deduction, up to $12,200 for single individuals and $24,000 for married couples. That’s something.
I don’t, however, see a dramatic impact on middle-income folks. So, if your first question is whether your wallet will feel substantially fatter at the end of 2018 if the plan passes, sadly, my answer to you is I don’t think so.
The brackets are far simpler; under the new plan, we would go from having seven tax brackets down to four. The highest bracket is currently reserved for families bringing in over $470,000 per year. Under the new plan, that number will more than double to $1 million.
My big picture reading? There are a few bright spots and a few potholes. Let’s dive into the details.
1. The Corporate Side of Cuts – For companies, the new tax plan carries the potential for a far more dramatic impact. Included is a tax cut from 35% down to 20%. The cut could create billions of dollars in new profits for the companies in which you and I invest. Realistically speaking, most companies have a much lower effective rate than 35% – many fall approximately in the 27% range. But even if the corporate tax compromise ends up at 23%, we’ll still probably see an uptick in company earnings.
This provision benefits investors. When earnings go up, the stock market goes up, and shareholders reap the rewards.
2. The Alternative Minimum Tax (AMT) – Under the new plan, the AMT is slated to disappear. Right now, over five million Americans have to pay the AMT, as it impacts folks in the $130,000 to $500,000 income range. The AMT imposes a higher tax rate if you have income that is subject to a lower tax rate than your earned income bracket.
For example, let’s say you have $150,000 in regular wage income, and you sell a house for $250,000. That sale gets taxed at the long-term capital gains rate (a lower rate than that for your income). Here, the current tax code prevents you from having that much income taxed at such a low rate. How? With the AMT.
If passed, this provision may be beneficial for folks with taxable income at differing rates come tax season.
3. Small Businesses – The new plan proposes a tax of 25% on pass through entities, such as LLCs and S-corps. Here, think small business owners, like home repair companies, consultants, and small manufacturers. Instead of a flat 25% tax, what we’ll most likely see is a mix between 25% and the business owner’s individual tax bracket.
4. Charitable Deductions – While the new plan slashes most itemized deductions, here, we see a deduction increase to 60% for charitable contributions. This means that donors get to take a deduction on cash contributions equal to up to 60% of their adjusted gross income.
5. State and Local Tax (“SALT”) Deductions – Simply put, residents in states with high-income taxes lose out here. The current federal deduction for the state and local taxes we pay are among the itemized deductions that Congress seeks to limit. These levies include property, income or sales taxes, and stand to be capped at $10,000.
Say you live in a high tax state, with a 10% state income tax. If your income is $400,000, you would pay $40k in SALT. Now, you can take the whole amount as a deduction. With the new plan, you could only take a deduction of $10,000 for the amount you paid.
Under the current SALT deduction allowance, your tax would be lowered by approximately $15,000. With the new plan, you would save only about $3,000. There will be a mammoth fight over this provision, and you can see why.
6. Mortgage Interest Deduction – I found this one surprising, as I believed Congress wouldn’t touch the mortgage interest deduction. But I was wrong. The plan would apply limits to the mortgage interest deduction: new buyers of primary residences would be able to deduct interest on loans only up to $500,000, which is down from the current $1 million cap.
7. Some Cuts May Turn into Increases – Already, research that shows that in some cases (particularly in families with several children), an initial tax cut could end up becoming a tax increase over the next 10 years.
Consider a married couple with two kids and a combined yearly income of $59,000:
- First, there’s a new “Family Flexibility Tax Credit,” which allows a $300 credit for the tax filer and spouse, but is set to expire after 2022.
- Second, the plan repeals personal exemptions. Under current tax law, these allow for a $4,150 write off per person in our example household as of 2018. The personal exemption in the plan is, in part, replaced by an expansion of the Child Tax Credit (of $600 per child) and the Family Flexibility Credit. However, the personal exemption is indexed to inflation under current law, and the replacements are not.
- Third, the plan indexes the tax system to a measure of inflation that would provide somewhat lower cost of living adjustments each year on average. This results in a slowly growing tax increase over time.
As I said, there’s a little something in the plan for everyone. Overall, it’s a mixed bag. Some sacred cows are being put to the test, like SALT and mortgage deductions. But, elimination of the AMT is a potential big win for millions of families. On the corporate side, lower overall rates are a big deal for jobs, earnings, and for investors.
If I were you, I wouldn’t redo my budget just yet based on this proposal. And I wouldn’t focus my attention on the few hundred or few thousand bucks this might save me. I would put more emphasis on investing for the next ten years, as this tax overhaul if passed, could end up benefiting investors in US businesses most of all.