“The tax law 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. “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 new law includes several important policy changes of interest to investors, beginning in 2018, including:
- Changes to individual tax brackets and rates. The new law 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.
The law 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 new law 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.
- Child tax credit. The law 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 law 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, many fewer taxpayers are likely to find themselves subject to the AMT in future years.
- Education savings. The law expands 529 plans to include tax-free distributions of up to $10,000 per year per student to pay for K–12 expenses. Previously, 529 plans offered tax-free earnings growth and tax-free withdrawals only for college expenses.
- Estate, gift, and generation-skipping transfer taxes. The law doubles the estate and gift tax basic exclusion amount to $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 new law preserves most of the existing incentives for investors and retirement savers, including:
- Tax cost of securities. The law 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 this 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 law retains the 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) plans and IRAs, workers (in the case of 401(k) plans) 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 new law continues to let employees save up to $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 50 and over.
IRA recharacterizations of conversions are going away
Chief among the new law’s features affecting retirement savers is the elimination of an investor’s ability to recharacterize a conversion to a Roth IRA made after the 2017 tax year.
It’s not unusual for retirement savers to convert a traditional IRA to a Roth IRA so they can pay tax on the account’s current earnings with the hope of having all future earnings grow tax-free. But some of these investors may decide to reverse this conversion for various reasons, including because the current tax cost ends up being too high or because the account fell in value. Rather than paying tax at the higher value at the time of the conversion, they opt for a recharacterization, which allows them to undo the conversion and take the converted money out of the Roth IRA and put it back into the traditional IRA.
Maria Bruno, a senior investment strategist at Vanguard, points out that investors who made a conversion in 2017 should be aware that they still have time to recharacterize that conversion. “While the new tax law prohibits recharacterization of a conversion made after December 31, 2017, investors who made a conversion in 2017 still have until October 15, 2018, to recharacterize it,” Ms. Bruno said.
The new law continues to allow 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. For example, an individual may make a contribution for a year to a Roth IRA and, before the extended due date for the individual’s income tax return for that year, recharacterize it as a contribution to a traditional IRA. An individual may also make a contribution to a traditional IRA and convert that traditional IRA (or a portion thereof) to a Roth IRA for a year, but could not then unwind the conversion through a recharacterization.
Investors who are considering a recharacterization of a contribution or 2017 conversion should consult a qualified tax advisor for advice.
“While the new law includes several features that may require investors to evaluate their tax situation, we are pleased that the final version preserves many of the incentives to save and invest,” Ms. Bruno said.
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.