Rethinking Retirement Planning With the New Tax Reform Bill
The total impact of the new tax reform bill recently signed by President Trump will take a good deal of time to unfold. Major media outlets seem to be having a field day espousing either doom and gloom or euphoria, depending on their political slant.
But despite the bill’s complexity, there are some very clear benefactors. Two groups in particular will benefit who seem to fall below the media’s otherwise intense purview. Namely, the working poor and lower-income retirement savers.
The Working Poor
The working poor will see several very tangible improvements in the new tax bill. These will play out differently depending on each individual’s situation, but in general, they appear to be quite favorable.
The working poor tend to be renters, not owners. As such, they tend to use the standard deduction instead of itemizing. The standard deduction will increase from $6,350 to $12,000 for taxpayers filing as single, and from $12,700 to $24,000 for married couples filing jointly. This alone is huge, though some of the impact will be mitigated by other changes for certain taxpayers.
For example, the personal exemption has gone the way of the dinosaur.
This will offset the gains of the increased standard deduction for some taxpayers.
But there is still another silver lining in this cloud. The child tax credit will increase dramatically from $1,000 to $2,000. Note that this is still considered a credit, meaning that it has a much greater impact on taxes than a deduction does. This is because a deduction is taken before your tax rate is applied, so it affects your taxes based upon the rate. For example, a $2,000 deduction at a 20-percent tax rate would lower taxes by $400 ($2,000 x 0.2 = $400). A $2,000 credit is applied directly to the tax and lowers it by that same amount. The new increased credit is partially refundable, up to $1,400.
The net effect of these changes — the increased standard deduction, loss of the personal exemption, and increase in the child tax credit — should result in a significantly lower tax burden for the vast majority of the working poor. Of course, some will benefit more than others. Those who paid no tax before won’t get any more relief. But those who work and have struggled to make ends meet should be helped by this tax bill.
Lower-Income Retirement Savers
The second large group of people who stand to benefit are lower-income retirement savers. And this may also extend into middle-income folks in more than a few cases.
The increased standard deduction and lowered tax rates mean that many people need to re-think their approach to retirement savings. There may be a new windfall for lower-income retirement savers in particular.
Many individuals contribute to a 401(k) or IRA with pre-tax dollars. The effect of using pre-tax dollars is that you save a portion of your contribution equivalent to your marginal rate. In turn, these contributions grow tax-deferred and aren’t taxed until taken as withdrawals in retirement.
Conversely, other retirement savers contribute to a Roth 401(k) or Roth IRA. While no tax deduction is available for these contributions, they also grow tax-free.
Unlike the traditional 401(k) or IRA, retirement distributions from a Roth 401(k) or Roth IRA are not taxable. This means that you’ll have more spendable income in retirement, as your withdrawals are not subject to federal income tax.
For lower-income retirement savers, a Roth 401(k) or Roth IRA has distinct advantages, as they may not benefit from pre-tax savings due to having little to no tax obligation to begin with.
The new tax law increases the number of people who should be considering a Roth 401(k) or IRA instead of a traditional one.
If you gain no tax advantage from making a pre-tax contribution, use a Roth plan instead. You still have tax-free growth, and then you’ll get a real windfall in retirement: a source of tax-free funds to supplement your retirement income.
As always, any tax savings depend upon a person’s particular situation. In the case of retirement savings, the benefits of a Roth plan over a traditional one will extend to a lot more people.
Run the numbers for your own situation to check whether you’re still getting a tax advantage from a traditional plan. If not, consider using a Roth plan as an alternative.
Additional Considerations for Retirement Planning
An additional retirement planning consideration comes about as a result of tax reform. In addition to Roth plans becoming attractive to a more people, Roth conversions will likewise make more sense for a larger number of persons.
In a Roth conversion, you change a traditional IRA into a Roth. People do these conversions so that they can have access to tax-free withdrawals from the Roth in retirement. The conversion itself is a taxable event that you should consider very carefully.
The increase in the number of people who have little or no tax liability due to the favorable conditions of the new tax reform package means that more people will be able to benefit from a Roth conversion. Low-income taxpayers converting relatively small traditional accounts into Roth accounts can gain long-term benefits with relatively fewer up-front costs than they had before tax reform.
The Bottom Line on the Tax Reform Bill
The tax reform package is a lengthy and complex piece of legislation. There will be winners and losers. Tax rates and other factors will fall out in your tax calculations; and you will also see gains — or not — depending on where you fall. Most people will, though.
The final factor in how tax reform will affect you is what choices you make. Choices about educating yourself on the changes and making the smartest money moves for your own financial situation. That is what being financially literate is all about: Knowing your options and making an informed choice based on your situation.
For many taxpayers, there are new considerations that can help them become financially independent through retirement savings. That’s important to look at, whether the news media told you it was there or not.