Implications of Tax Reform for Retirement Planning

Tax reform stirred up a lot of debate. Fortunately, the Tax Cuts and Jobs Act did not greatly modify the retirement savings vehicles that often house index funds and a variety of other investments. However,  prudent and intelligent investors will still want to stay educated about all of the tax bill’s implications to generate greater wealth for retirement.

What Changed?

Some of the major changes due to tax reform include an extension of loan repayments to qualified retirement loans because of loan default related to job termination. While lawmakers still allow the “back-door” contribution to the Roth IRA known as Roth conversion, they no longer allow Roth conversion re-characterizations. In other words, if you convert money from a Traditional IRA into a Roth, you can’t change your mind and put the same funds back into the Traditional IRA. (Some investors essentially undid the conversions to avoid paying taxes on a higher amount if they experienced a loss after converting). Some of the other tax reform changes that matter to retirees include corporate tax cuts on employee retirement plans, increases in estate tax exemption and changes in the standard deduction.

Making the most of a Roth IRA

The Roth IRA remains one of the best retirement savings vehicles for self-employed people and others. While most employees should strive to receive any company match to contributions to a 401(k), the Roth IRA is a great second place to park retirement savings. Also, investors generally have more investment flexibility to invest in index funds within a Roth IRA. Some 401(k) plans have limited investment options.

With the new tax law, any conversions from a traditional IRA to a Roth made after 2017 can’t be re-characterized. But if you contribute too much money to a Roth by mistake, you can re-characterize the excess contribution. In those cases, the extra Roth IRA contribution is made to a Traditional IRA. Re-characterizing retirement money is an extremely useful strategy, especially for high-income earners who don’t qualify to directly contribute to a Roth IRA. Even though you pay taxes on the conversion amount, it’s ideal to have money growing tax free in a Roth.

Having more time to pay back a loan

A lot of people take out loans from a qualified retirement savings plan.  In the past, workers had 60 days to pay off the loan loan balances if they left an employer. Under the new law, the worker has until the tax return date and any extensions for the year the loan-offset occurred. For workers, this helps by providing extra relief and more time to repay the loan. Otherwise, the individual pays income tax on the loan proceeds they could not repay.

Mortgage interest deduction changes

Of course, retirement savings is not just about investing in index funds and fully funding a Roth IRA and 401(k) plan. Paying down a mortgage is a forced retirement savings approach for many Americans. The new tax reform changed mortgage interest deduction. In 2018, interest on home equity debt is not deductible.

For rental property owners, however, all the former benefits remain in place. When it comes to a home in which you reside, the cap was lowered from $1 million to $750,000 for mortgage interest deduction. Most tax experts believe fewer taxpayers will decide to itemize and receive the mortgage interest deduction. One interesting way wealthier taxpayers are responding to the tax change is to rent out their second homes or vacation homes. By turning a second home into an investment property, the owner gains greater tax benefits. Again, real estate investors continue to enjoy property tax deductions, mortgage interest deductions, depreciation and expense deductions.

Giving back to the community

Making charitable contributions and giving back is another major part of retirement planning. Tax reform creates greater benefits for qualified charitable distributions or QCD. When a person takes a distribution from an IRA, the money boosts tax liability by increasing adjusted gross income. But QCD allows investors age 70 ½ or older to give money from an IRA to qualified public charities. In these cases, the IRA owner does not boost his or her adjusted gross income.

While the QCD rules did not change, it’s likely fewer people will deduct their contributions because they would have to itemize. The QCD counts toward the required minimum distributions that those over 70 &1/2 are required to make to avoid paying a penalty to the IRS. For charitable people who continue to itemize their taxes, the QCD helps reduce the tax burden.

Giving while the giving is good

Other important changes that matter a lot to retirees include the changes to estate and gift tax exemptions. Under the old law, people had an estate and gift tax exemption of $5.6 million in their lifetime. Now the exemption is $11.2 million per person. However, keep in mind the exemption reverts back to the previous numbers upon expiration in 2025. Some of the tax reform rules are permanent, but not all of them. Because of the temporary nature of the estate and gift tax exemption, you may want to transfer wealth through 2025.

Getting a handle on tax reform makes it easier to plan for the future. It’s more important than ever to put money aside for retirement. Many investors celebrate the fact that there were no cuts in contribution limits. If individual tax rates go back to the old rules in 2016, it means there is a window of opportunity to pay taxes at a lower rate. Some people see this as a strong reason to max out Roth (IRA, 401k) savings opportunities. Also, a lower tax rate means some tax payers have a chance to convert money now from a traditional IRA to a Roth.

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