The most sweeping tax reform in a generation may have begun under the guise of simplification, but the application of the new tax rules will be anything but simple for financial advisers and their retired clients.
The Tax Cuts and Jobs Act that President Trump signed into law on Dec. 22 presents numerous tax planning opportunities and pitfalls. But it means some advisers will have to go beyond their comfort zone when it comes to discussing the tax implications of various withdrawal strategies.
"Clients expect their advisers to know and understand the benefits and potential landmines of their financial strategy," said Joe Elsasser, president of Covisum, a technology and training service that offers Social Security Timing and Tax Clarity software programs. "Advisers will no longer be able to hide behind disclosures stating that they do not provide tax advice."
In releasing a newly updated white paper explaining the intricate interaction of various types of income on the taxation of retirement income, Mr. Elsasser said, "Financial advisers and their clients cannot afford to get this wrong."
The new tax law lowers some tax brackets and nearly doubles the size of the standard deduction, to $12,000 for individuals and $24,000 for married couples who file joint tax returns in 2018. The larger standard deduction, coupled with new limits on some itemized deductions such as state and local property and income taxes, is expected to push more than 30 million people who itemized the past to choose the standard deduction.
The incentive is even stronger for taxpayers age 65 and older, who enjoy an even bigger standard deduction. In 2018, the standard deduction for a married couple where both the husband and wife are 65 or older will be $26,600.
"A bigger standard deduction creates more room for Social Security benefits to come through tax-free," Mr. Elsasser said. But swapping out itemized deductions for a bigger standard deduction does not necessary lead to a simplified tax return.
For example, the top of the 12% tax bracket for married couples in 2018 is $77,400. That means a married couple who had $40,000 of Social Security benefits and $15,000 in IRA withdrawals would pay no federal income tax in 2018. That's because the taxable portion of their Social Security benefits ($1,500) when added to their taxable IRA withdrawal of $15,000 brings their total taxable income to $16,400. But with $26,600 in allowable standard deductions, the elderly couple would pay no federal income tax for the year. Their net taxable income would be a negative $10,100.
Many advisers might consider taking an extra $10,100 out of the IRA. Conceptually, a negative $10,100 result would mean a client could add $10,100 of taxable income without paying tax, right? Not quite. An additional IRA withdrawal of $10,100 would create additional taxable income of $17,385.
If clients had only Social Security benefits, they would be entirely tax-free. But once you begin to add other types of income, such as IRA withdrawals, Social Security benefits begin to become taxable. In the above case, each dollar over $12,000 withdrawn from the IRA causes $1.50 to appear on the tax return, causing an outsized negative impact on the client's tax situation.
Another example of this complicated tax landscape is the impact of capital gains. If a married couple over age 65 had only long-term capital gains and qualified dividends and no other income in 2018, they could take $103,800 and pay zero federal income tax. That's because any long-term capital gains or qualified dividends that occur while the client's adjusted gross income is under $77,200 receive a 0% tax rate. But when a client has capital gaind and also is collecting Social Security benefits, it means a portion of Social Security becomes taxable.
"The combination of Social Security with ordinary income, such as IRA withdrawals and capital gains, can create a snowball effect where the resulting tax on one additional dollar of income recognized is far great than what is expected," the Covisum white paper explained.
Working retirees may be able to substantially reduce their 2017 tax bill by contributing to a traditional tax-deductible IRA before the April 17 tax deadline, Mr. Elsasser said. In the fall, advisers should review their clients' tax situation to see if they may want to withdraw more than their annual required minimum distribution from their IRA to take advantage of lower 2018 tax rates or even consider a partial conversion to a Roth IRA.
With fewer taxpayers expected to itemize in the future, retired clients now have a very valuable tax planning tool: qualified charitable donations. Taxpayers age 70½ and older can make contributions directly from their IRA to qualifying charities. The donations count toward the IRA owners' required minimum distribution but the payout doesn't show up in taxable income, which can reduce both tax bills and future Medicare premium surcharges that are tied to income.