Vanguard's take on the tax bill

December 20, 2017

 

Editor's note: The IRS has clarified that Roth IRA conversions made in 2017 can be recharacterized until October 15, 2018. Under the tax changes signed into law on December 22, 2017, Roth IRA conversions made in 2018 and beyond cannot be recharacterized.

With both the House and Senate passing identical legislation this week and President Trump poised to sign the compromise agreement into law, efforts to change the tax code are nearing the finish line. The wide-ranging bill generally lowers tax rates for corporations and individuals, though its impact will depend on individual taxpayer circumstances, as the lower rates also come with many changes to deductions and exemptions. The bill preserves most of the existing incentives for saving and investing, but it includes several policy changes that bear watching by investors and retirement savers.

"The tax bill contains wide-ranging changes that will affect investors of all kinds, from individuals and participants to advisors and large institutions," said Bill McNabb, Vanguard chairman and chief executive officer. "Naturally, we'll continue to examine all of the provisions to determine the best ways to help our clients meet their goals. Additionally, given the complexity and breadth of changes, it's important that investors consult with a qualified tax advisor to determine whether and how the new legislation will impact them."

Notable changes for investors

The compromise agreement includes several important policy changes of interest to investors, including:

  • Changes to individual tax brackets and rates. The agreement maintains seven income tax brackets but adjusts the tax rates and income levels, including lowering the top rate from 39.6% to 37%. It also maintains the current preferential rates for long-term capital gains and qualified dividend income but redefines the income levels for those rates based on specific dollar amounts, rather than adjusting them to the new income tax brackets.

Tax reform graphic

The agreement also maintains the 3.8% Medicare tax on the net investment income of taxpayers with a modified adjusted gross income over $250,000 for married couples or $200,000 for individuals.

  • Higher standard deduction, elimination of personal exemption, and reduction in itemized deductions. The legislation essentially doubles the standard deduction to $12,000 for individuals and $24,000 for families, eliminates the personal exemption, and reduces or eliminates several itemized deductions. The result of these changes will be that fewer people will itemize their deductions, so items such as charitable contributions and mortgage interest may no longer be relevant for some. Investors should consider whether to take any action prior to the end of the year in light of these changes. For instance, if an individual will itemize for 2017 but use the higher standard deduction in 2018, they may want to consider making charitable contributions for next year by the end of the month.
  • Child tax credit. The agreement also doubles the child tax credit to $2,000 per qualifying child under age 17 and creates a new dependent tax credit of $500 per qualifying dependent not eligible for the child tax credit. Each is subject to income phase outs.
  • Alternative minimum tax. The agreement eliminates the corporate alternative minimum tax (AMT) but retains it for individuals, with increased exemption amounts of $109,400 for married couples and $70,300 for individuals for 2018 (up from 2017 levels of $84,500 for married couples and $54,300 for individuals) and much higher phase-outs of these exemption amounts. Because of these changes and the generally lower deductions allowable for individuals, fewer taxpayers are likely to find themselves subject to the AMT in future years.
  • Education savings. The agreement expands 529 plans to include tax-free distributions of up to $10,000 per year per student to pay for K-12 expenses. Currently, 529 plans offer tax-free earnings growth and tax-free withdrawals only for college expenses.
  • Estate, gift, and generation-skipping transfer taxes. The compromise doubles the estate and gift tax basic exclusion amount to $10 million after 2017 (adjusted for inflation, exemption is $11.2 million for 2018) and retains the stepped-up basis in estate property.

Savings and investing incentives mostly preserved

Despite several important changes, the legislation preserves most of the existing incentives for investors and retirement savers, including:

  • Tax cost of securities. The final bill preserves the longstanding ability of fund investors to specifically identify shares of a security to be sold, giving them the flexibility to manage the timing of the recognition of their capital gains and losses. The Senate proposal would have eliminated this ability, and generally required shares of a security to be sold after December 31, 2017, on a first-in, first-out (FIFO) basis or, in the case of fund and dividend reinvestment plan shares, average-cost basis. Maintaining the existing policy offers greater flexibility and reduces the tax burden for many investors, as mandatory FIFO requirements generally would have resulted in high capital gains taxes, particularly for long-term investors.
  • Exemption of interest paid on private activity bonds. The final bill retains the current tax exemption for interest paid on private activity bonds—municipal bonds that are used for multi- and single-family housing; airports; water and sewer facilities; and nonprofit hospitals and universities. The House bill would have eliminated this exemption, which could have had a big impact on the supply and price of these bonds in the municipal market.
  • Retaining tax deferrals for 401(k) plans and IRAs. With tax-deferred 401(k)s and IRAs, workers (in the case of 401(k)s) and individuals will continue to be able to set aside money before federal and state income taxes are withheld.
  • Preserving current contribution limits for 401(k) plans and IRAs. The final bill continues to let employees save up to $18,000 for 2017 and $18,500 for 2018 in a 401(k), and individuals can continue to save up to $5,500 in an IRA. The catch-up contribution limit for employees age 50 and over who participate in a 401(k) will remain unchanged at $6,000, as will the additional catch-up contribution limit of $1,000 for IRAs for individuals age 50 and over.

IRA recharacterizations of conversions are going away

Chief among the bill's features affecting retirement savers is the elimination of an investor's ability to recharacterize a conversion to a Roth individual retirement account (IRA) after the 2017 tax year.

According to Maria Bruno, Vanguard senior investment strategist, questions remain about what happens to those who make a conversion in 2017. "Under current law, you'd have until October 15, 2018, to change your mind and recharacterize a conversion you made for 2017," Bruno said. "But it's unclear under the new law whether retirement savers will have until the end of this year or until October 15 of next year to do a recharacterization. We hope that the IRS will provide clarifying guidance on this in the near future."

Absent guidance from the IRS providing otherwise, Vanguard will continue to permit investors to recharacterize their 2017 conversions through October 15, 2018. Investors who choose to recharacterize after the end of December 2017 should understand that there is some risk that the IRS could ultimately disallow their recharacterization transaction, potentially resulting in adverse tax consequences to them.  Because of this uncertainty, Vanguard suggests that investors who are considering a recharacterization of a 2017 conversion consult a qualified tax advisor and make a decision by the end of the 2017 calendar year.

The final bill maintains the current law permitting the recharacterization of a contribution to a Roth or traditional IRA and reflects a change from the original House- and Senate-passed bills, which also would have eliminated this option.

"While the bill includes several features that may require investors to evaluate their tax situation, we are pleased that the final bill preserves many of the incentives to save and invest," Bruno said.

Notes:

  • We recommend that you consult a tax or financial advisor about your individual situation.
  • All investing is subject to risk, including the possible loss of principal.
  • The information contained herein does not constitute tax advice, and cannot be used by any person to avoid tax penalties that may be imposed under the Internal Revenue Code.
 

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