Two HUUUGE Questions About The Biggest Tax Cut In American History

Stock markets rallied this week in anticipation of, and in reaction to, the President’s tax plan. Probably the biggest concern on most people's’ minds has been, "What do I stand to lose?" Meanwhile, policy makers must wrestle with who will  “pay” for tax cut proposals (as much as $7 trillion by some estimates) by closing loopholes. Of course, what may be a loophole to some is considered sacrosanct to others. Even though many important details are still lacking, there do seem to be some answers to the two most common questions I’ve fielded in conversations over the past few weeks.

Will I still get a deduction for making retirement contributions?

Initially, the president’s press secretary, Sean Spicer, was quoted as saying the proposal only included tax deductions for charitable giving and mortgage interest, “that’s it.” Afterwards, he clarified that the plan did NOT include doing away with the deduction for making retirement account contributions. It does make you wonder how close of a decision it was, given the recent report from the Congressional Joint Committee on Taxation showing that about $1.5 trillion in taxes could be raised in the next decade by changing how the upfront tax benefits of those accounts are currently treated.

For now, most retirement account contributions such as your salary deferrals, company matching, profit sharing, etc, are made pre-tax. The growth of the account is then tax deferred until retirement, where the proceeds are taxed upon withdrawal.

One proposal being examined is treating all retirement account contributions in the same manner as Roth IRAs, that is, you would receive no tax break on the front end but you wouldn't pay taxes upon withdrawal either. Believe it or not, arithmetic doesn’t favor paying a certain percentage in taxes sooner versus later.

Consider this simple example. You are in a 25% tax bracket and invest $1,000 for 10 years at 7.2%.

  1. Pre-Tax, Tax Deferred:  You put in $1,000, it grew to $2,000, and you owed $500 (25%) in taxes upon withdrawal, leaving you with $1,500.
  2. Post-Tax, Tax Free: You put in $750 ($1,000 minus 25% tax), it grew to $1,500, and you owed nothing in taxes, leaving you with $1,500.

Conventional wisdom is that you will be in a lower tax bracket in your golden years, but the more complicated reality is that your tax situation may change by circumstances that can be challenging to control, such as exceeding Social Security taxation levels, having Required Minimum Distributions push you into a higher tax brackets, and/or the potential for higher tax rates in the future driven by the voracious government appetite for spending.

So, yes, your deduction for this year’s retirement contribution appears safe. Even if the upfront tax benefits were to go away, however, it is likely that you would still see significant benefits to continuing your contributions.

Should I wait for capital gains taxes to go down to take a profit?

Depending on your current income tax bracket, long-term capital gains (LTCG) are currently taxed as low as 0% and as high as 23.8%. The White House proposes dropping LTCG rates to a high of 20% by eliminating the 3.8% Medicare surtax that is currently added on to LTCG rates for single taxpayers with adjusted gross income over $200,000 or $250,000 for joint. The House GOP’s, “A Better Way” has proposed reducing the top rate on LTCG even further, to 16.5%.

If you made a $1,000 investment over a year ago that is now worth $2,000, the most you potentially owe in Long Term Capital Gains + Medicare surtax is $238, or about 12% of the overall value of your holding. Even if the GOP’s 16.5% proposed LTCG rate were to become law, your tax burden would only shrink to $165, or to about 8.25% of your holding. Considering that 10%+ stock market corrections occur about once per year, it wouldn’t be surprising (and it may even be likely) that the next dip will cost you more than you would have saved by waiting.

I typically recommend not waiting to liquidate any amount you foresee spending in the next couple of years, regardless of pending tax laws. History suggests that it is likely we will see a swoon or two in that timeframe that could easily exceed any potential tax savings.

Everyone's situation is different, which is why you shouldn’t wait on having a plan in place. Get in touch if yours needs review.