TAX BILL CONSIDERATIONS FOR RETIREMENT PLANNING

Overview

Widespread tax cuts generally result in a marked decline in government revenues and/or cutbacks in services or other areas. One area Congress considered cutting back was the amount of tax-deferred contributions that workers could make to employer-sponsored retirement plans. One proposal recommended scaling back contributions from the current limit of $18,000 a year to as little as $2,400.

As one recent survey confirmed, it is likely that Americans would save even less for retirement than current levels if not for the tax-deferred status of their 401(k) plan contributions. Indeed, proposals that discourage retirement savings are probably not in the best interest of Americans or the government itself — which would inevitably bear the burden of providing more Social Security benefits for those who do not save enough.

With that being said, there are several ways in which the new tax legislation could impact retirement plans moving forward.

“The Wells Fargo/Gallup Investor and Retirement Optimism Index found nearly half of U.S. investors would save less or stop saving if the tax-deferred status of their 401(k) plans was removed.”

Roth IRA

Conversion Recharacterization

The Tax Cuts and Jobs Act eliminated Roth IRA conversion recharacterizations, which permitted Roth assets to be returned to a traditional IRA before the tax return date (plus extensions) in the year of the original conversion. The conversion recharacterization rule enabled an investor to basically change his mind about transferring pre-tax savings to a Roth IRA and paying income taxes in the year converted. Going forward, investors who convert a traditional IRA to a Roth IRA no longer have the option to reverse that decision.

Note, however, that conversions made in 2017 can still be recharacterized by as late as Oct. 15, 2018.

IRA recharacterizations in the past were used as a tool to convert just enough assets to stay within an investor’s current income bracket. A traditional IRA owner could transfer a portion of assets to a Roth IRA in order to offet his future tax bill during retirement. However, if his income at the end of the year tipped over into the next tax bracket, he could recharacterize some of those IRA assets so as to walk back to a lower income bracket.

Now that recharacterizations are no longer permitted, investors need to be more precise in the amount converted in any one year, possibly waiting till the end of the year — but before the deadline of Dec. 31.

Roth Contributions

One reason a Roth IRA can be an attractive alternative to a traditional IRA is because it enables income tax diversification during retirement. So many retirement savings vehicles are qualified — meaning the investor defers paying taxes on contributions and/or earnings until retirement. As a result, retirees who have saved diligently may be surprised at how big their tax bill is after they stop working.

Because of the new Tax Cuts and Jobs Act, more investors may find they are paying lower taxes on their income. With current taxes less of an issue, it may be worth considering stashing more money in a Roth at this point in order to reduce the future tax burden in retirement.

Presently, about 52 percent of retirement plan sponsors in the U.S. offer a Roth 401(k) investment option.4 Note that by diverting after-tax income to a Roth 401(k), investors can take advantage of a higher annual contribution limit (in 2018: $18,500; $24,500 for age 50 and up) than a separate Roth IRA.

Qualified Retirement Plans

Loan Repayment

The new tax law also extends the time required to repay money borrowed from a 401(k) plan before it becomes taxed as immediate income. Prior to this year, if a participant left his employer before paying of the loan, he would have only 60 days to repay the loan before it became taxable. The new law extends that window to the tax return deadline — plus any extensions filed — for the tax year the employee terminated employment.

Charitable Distributions

People who make charitable contributions can claim a deduction for those amounts by itemizing on their tax return. The new tax law, however, has raised the standard deduction to the point where itemizing may no longer be an advantage.

IRA owners age 70½ or older are still permitted to make qualified charitable distributions (QCDs) directly from their IRAs to charities. Not only does this strategy exclude the distribution from the owner’s taxable income, but it also qualifies as all or a part of the IRA’s required minimum distribution (RMD).

In light of fewer people itemizing going forward (estimated between 5 and 10 percent of filers), these qualified distributions may become more popular. That’s because the QCDs are shielded from taxes and do not impact the taxpayer’s reported AGI. In turn, this keeps his tax bracket low, possibly avoiding taxes on Social Security benefits and keeping Medicare premiums down.

Medical Deduction

The new tax law extended the 7.5 percent medical deduction for seniors and increased the deduction to 10 percent in 2019. However, with the increase in standard deduction, it is estimated that fewer seniors will be able to use the deduction because they no longer need to itemize.

Estate Taxes

Under the new law, the estate tax exemption increased from $5.6 million to $11.2 million per individual until 2025, indexed for inflation. Each person may gift up to $15,000 each year without intruding on that “lifetime” (2025) gift tax exemption.

This means that ultra high net worth households may want to take advantage of this window to give away up to $22.4 million (for a married couple) to heirs before 2025. Strategic gifting tactics may include:

  • Gifts to existing or new irrevocable trusts, including generation-skipping trusts
  • Leveraging a gift to fund a life insurance policy
  • Using a gift to leverage an inheritance with philanthropy, via vehicles such as a charitable lead trust

Final Thoughts

The new tax law went into effect on Jan. 1, 2018, which means it will impact our 2018 tax returns — to be filed by April 15, 2019. While there are no major changes required for retirement planning as a result of the new legislation, the provisions and strategies discussed in this report could impact your situation, such as:

  • Improved opportunities for tax diversification
  • Decisions related to itemizing
  • Leveraging charitable contributions to keep income taxes low
  • Taking advantage of the seven-year window to gift substantial wealth to heirs without triggering estate taxes

As always, it’s a good idea to consult with your financial advisor and/or tax professional before making any significant moves. When it comes to assets and taxes, it’s always best to view your financial picture holistically because one move can impact others.