The Tax Cuts and Jobs Act, passed into law in late 2017 and mainly taking effect in 2018, will be transformative for many Americans and businesses. For the most part, tax laws relating to retirement plans and retirement planning were left alone, with no major modifications. This came as a bit of a surprise as there had been much conversation and numerous proposals regarding tax reforms that could have drastically changed retirement planning in the United States. But, as the final bill rolled out, very few of these changes made the cut.
Below you will find a summary of changes that directly impact retirement planning, as well as a general discussion on the overall impact of the new tax bill on retirement planning. The goal is not to identify the numerous ways that income taxes and tax reform will impact retirees, but instead to focus on the tax laws that more specifically target retirement plans and retirement planning.
The nine major changes to retirement planning resulting from the Tax Cuts and Jobs Act are:
1) The removal of Roth conversion recharacterizations.
2) Extension of qualified retirement plan loan repayments due to loan default at termination.
3) Changes to 2016-2017 disaster relief distributions.
4) The impact of changes to mortgage interest deductions on forward and reverse mortgages.
5) Heightened benefits of qualified charitable distributions due to a higher standard deduction.
6) Extension of the 7.5% medical deduction limit for seniors.
7) Estate tax exemption increased.
8) Corporate tax cuts and 199A impact on qualified employer retirement plans.
9) Increased concern about cuts to senior retirement programs like Medicare.
1) Removal of Roth Conversion Recharacterizations
Old law: An IRA could be converted to a Roth IRA, and recharacterized (assets sent back to an IRA) before the tax return date, plus extensions, for the year of the conversion. This essentially allowed a taxpayer to undo a conversion of an IRA to a Roth IRA by Oct. 15 of the year following conversion.
New law: Conversions from an IRA to a Roth IRA made after 2017 can no longer be recharacterized. Conversions made in 2017 can still be recharacterized by Oct. 15, 2018. Even though IRA conversions can no longer be recharacterized moving forward, an individual who contributes too much to a Roth IRA can still recharacterize the excess contribution as if the contribution was made to a traditional IRA.
Potential impact on planning: Recharacterizing a conversion has been a useful planning tool for a number of reasons. Since conversions have to occur before the end of the tax year for which the conversion will be taxed, the individual has to make a conversion decision before all tax information is known. Before, an individual could err on the side of converting too much, then recharacterize any excess amounts. A common strategy often called bracket bumping is to convert enough each year to use up a particular tax bracket. As a result of the new legislation, bracket-bumping conversions must now be done with more discipline and restraint moving forward. Additionally, the removal of Roth recharacterizations stops the strategy of converting multiple investment accounts and then waiting to recharacterize those accounts that went down in value or did not grow substantially.
2) Extension of Qualified Loan Repayment
Old law: If a participant had an outstanding loan balance in a qualified retirement plan, a 403(b) or 457(b), at the time of plan termination, or because of a default on the loan's repayment terms due to the employee's separation from service, the plan could treat the reduction in the benefit due to the outstanding loan balance as a "loan offset amount." To avoid having to pay taxes on the outstanding balance, the participant had 60 days to come up with the additional funds to roll the loan offset amount to an IRA or other eligible plan.
New law: Instead of 60 days, the taxpayer now has until his or her tax return date plus any extensions for the year in which the distribution that included the loan-offset amount occurred. This is still only allowed when the loan default was due to termination of the plan or failure to meet the loan repayment requirements due to separation from service.
Potential impact on planning: This change could provide some additional relief to anyone defaulting on a plan loan due to termination of the plan or separation of service by allowing more time to repay the loan without having to take the loan proceeds into income.
3) Disaster Relief Changes
Old law: Traditionally, if you take money from an IRA or retirement plan, a taxpayer owes ordinary income taxes on a taxable distribution and a penalty tax if the distribution is taken prior to age 59½ , barring any exception that applies. Generally, to avoid income taxation on a retirement plan distribution, the money needs to be rolled over within 60 days.
New law: A qualified "2016 disaster distribution" allowed taxpayers to withdraw money from an eligible retirement plan in 2016 or 2017 if the taxpayer had sustained an economic loss to their place of abode from a presidential-declared disaster area during 2016. The qualified 2016 distributions can now be included in a taxpayer's gross income ratably over a three-year period, starting in the year it was received. The taxpayer can also elect to treat all the income as taken in one year. Additionally, an exception from the 72(t) early withdrawal 10% penalty tax was created for qualified 2016 disaster distributions. Furthermore, qualified 2016 disaster distributions can be repaid to the plan within three years, starting on the day immediately following the date of distribution; thus, the taxpayer can also avoid ordinary income taxation on the distribution if it is repaid within the three-year period.
Potential impact on planning: For those impacted by 2016 presidential-declared disasters, a good bit of relief was created, which allows for favorable taxation and repayment of distributions from IRAs and qualified plans. However, it did not extend the time period to take a withdrawal into 2018, but instead provided backwards-looking relief for tax and repayment purposes.
4) Mortgage Deduction Changes
Old law: Under 26 U.S.C. Sec 163(h), a home mortgage interest deduction was allowed if certain requirements were met. Additionally, there were two different limitations on interest deductibility depending on the nature of the loan. First, for married filing jointly taxpayers, acquisition indebtedness was capped on interest on the first $1 million of a mortgage. Second, for married filing jointly taxpayers, home equity indebtedness was capped on interest paid on the first $100,000 of a mortgage. Whether a mortgage qualified as acquisition indebtedness or home equity indebtedness entirely depended on how loan proceeds were utilized. If the proceeds were to purchase, build or substantially improve a home, it was acquisition indebtedness. If the proceeds were used for anything else, like paying off credit card debt, cashing out equity, or another purpose, it was home equity indebtedness and subject to the lower limit.
Generally speaking, these rules also applied to the payment of interest on a reverse mortgage. Furthermore, the IRS treats obtaining a reverse mortgage as equal to refinancing a traditional mortgage for interest deductibility purposes, meaning the treatment of the original debt is transferred to the refinance. So, if you refinance a mortgage that qualified as acquisition indebtedness to another mortgage or reverse mortgage, you kept the nature of that acquisition indebtedness on the amount you refinanced of the original debt. However, if you cashed out additional funds during the refinance, those funds would be subject to limits based on how you used the cash out funds. To take advantage of the mortgage interest deduction, the taxpayer needed to itemize.
New law: Starting in 2018, interest on home equity indebtedness is no longer deductible. For home acquisition indebtedness, the cap was lowered from $1 million to $750,000. Additionally, the new limitation only applies to new mortgages taken out after Dec. 15, 2017. The old limits also apply to situations in which a home that was under contract to close on Dec. 15, was supposed to close by January, and actually closed by April 2018. Furthermore, a refinancing of existing acquisition indebtedness mortgages keeps the old limit of $1 million, but only for the remaining debt balance, not for any additional debt taken out.
Potential impact on planning: Generally speaking, it is expected that fewer taxpayers will be itemizing deductions under the new tax rules. Because of that, far fewer people will be deducting their mortgage interest. Home equity indebtedness interest is not deductible at all under the new guidelines. This could impact taxpayers with reverse mortgages, although the interest from a reverse mortgage is only deductible when the loan is actually paid back, typically at the death of the homeowner or otherwise when the loan becomes due. Refinancing cannot be used to solve the issue of the nondeductibility of home equity indebtedness interest. This also means that taxpayers need to be aware of the new tax ramifications of any refinance with a cash-out feature, as the cash-out amount could be treated as home equity indebtedness, depending on its usage, and the interest would not be deductible.
5) Increased Benefits of Using QCDs
Old law: Distributions from IRAs are generally treated as adjusted gross income (AGI) and are taxed as ordinary income. Qualified charitable distributions (QCD) allow IRA owners age 70½ or older to make distributions directly from their IRAs to a qualified public charity in a tax-advantaged manner. Such distributions are excluded from the IRA owner's income but at the same time are treated as satisfying the required minimum distribution requirements. Total annual QCDs from all IRAs cannot exceed $100,000 for an individual. Spouses can each donate up to $100,000 of QCDs.
New law: QCDs were not changed under the new law. However, the increased standard deduction will result in fewer taxpayers and seniors being able to deduct charitable contributions because it requires the taxpayer to itemize.
Potential impact on planning: Making a QCD as opposed to a normal charitable gift has two main advantages. First, a QCD counts toward satisfying the individual's required minimum distribution for that year. Second, the distribution is excluded from the taxpayer's income. It is this second benefit that really shines under the new tax bill. With very few individuals expected to itemize (some estimates say between 5% and 10% of filers), the income tax deduction for contributions to charities will be lost for many people. However, if you make a QCD, you get a full exclusion of that QCD from income taxes. In fact, the distribution does not impact the retiree's AGI at all. This can also help manage tax rates, avoid taxation of Social Security payments and keep Medicare premiums down. In essence, it's a fully deductible contribution that also helps satisfy an RMD requirement. So, for any retiree who is 70½ or older, owns an IRA subject to RMDs and is charitably inclined, a QCD really works out as a mechanism to preserve an income-tax-reducing charitable deduction under the new tax law. This should be a strategy that sees increased usage moving forward.
6) Medical Deduction AGI Limit
Old law: Medical expenses were only deductible if an individual itemizes and only to the extent that the total medical and dental expenses exceeded 10% of adjusted gross income (AGI). Up until 2017, those age 65 and over only had to meet 7.5% of adjusted gross income. However, starting Jan.1, 2017, all taxpayers were going to be required to meet the 10% AGI threshold.
New law: The 7.5% of AGI threshold for deductible medical expenses for those age 65 and over was extended to cover 2017 and 2018.
Potential impact on planning: The deductibility of medical expenses will return to the 10% of AGI limit in 2019, unless it is extended again by further legislation. However, it is expected that fewer seniors will utilize this deduction because fewer taxpayers will be itemizing their deductions moving forward.
7) Estate and Gift Tax Exemption
Old law: Individuals have a lifetime estate and gift tax exemption of $5.6 million in 2018.
New law: The Tax Cuts and Jobs Act doubled the exemption to $11.2 million per individual in 2018. The exemption returns to the previous amount after 2025. The exemption is indexed for inflation. Portability between spouses remains. The Tax Cuts and Jobs Act did, however, provide some ambiguous language that allows the Treasury Department to develop a "claw-back" mechanism for gifts made during the higher exemption years. It is unclear if the Treasury Department will develop subsequent rules.
Potential impact on planning: The prevailing thought is that high-net-worth individuals should take advantage of gifting and transferring wealth through 2025 while the increased exemption is in effect. However, the Treasury Department and IRS must be monitored in the event that they create any type of guidance or develop a "claw-back" rule in the future.
8) Corporate Cuts and Retirement Plans
Old law: There was a graduated corporate tax rate of up to 35%. A corporate/business deduction was allowable for contributions to qualified retirement plans, subject to certain limitations.
New law: Current law now sets the corporate rate at 21% and creates a 20% qualified business income tax deduction (199A deduction) for certain pass-through entities.
Potential impact on planning: The impact of lowered corporate rates and the QBI 20% deduction for pass-through entities on qualified plans is uncertain at this point. A lower corporate rate reduces the tax benefit to some degree of making a contribution to a qualified retirement plan. However, to qualify for the 20% QBI deduction, in certain situations it might make sense to contribute extra money to a qualified plan. The planning impact will really depend on a company's specific situation. The lower corporate tax rate and the 20% QBI deduction could both spur on additional contributions in some situations and disincentive corporate contributions in other situations.
9) Potential Cuts to Retirement Programs
Old law: A federal government budget rule, called Paygo, which stands for "pay-as-you-go," originally part of the Budget Enforcement Act of 1990, and more recently reestablished in 2010, essentially required that new legislation (including the new tax cuts) impacting government revenue does not increase budget deficits or else cuts must be made to mandatory spending.
New law: The Tax Cuts and Jobs Act is projected by the federal government to increase the budget deficit. This could trigger automatic or forced cuts to programs like Medicare.
Potential impact on planning: The Paygo rule has not been enforced consistently, as Congress has found numerous work-arounds and has waived the rules during certain years. It is not clear if the Paygo rule will be enforced in 2018, or if Congress will strike a deal to waive mandatory spending cuts to Medicare.
Lastly, it is important to note that tax reform will impact retirement planning in a number of other ways. First, charitable contributions could change substantially for retirees. As fewer retirees can benefit from the charitable contribution deduction due to an expected increase in standard filings, bunching charitable contributions might become more popular. This is the idea that you should group your charitable contributions all in one year to increase your potential deduction and ability to itemize. One technique for bunching charitable contributions involves the use of a donor-advised fund (DAF). Using a DAF allows the individual to take the deduction all in one year, but spread out the donations to specific charities from the DAF over time.
The good news for retirement planning is that there were no changes to any of the standard retirement savings vehicles and no cutbacks in contribution limits. From a planning perspective, what may change under the new law is the appropriate mix of tax-deferred and Roth contributions for your clients. Since many Americans will be paying taxes at a lower tax rate through 2025, as the individual tax rate cuts revert back to 2017 rules in 2026, there is a strong argument to more fully utilize Roth savings opportunities.
For retirees who were not itemizing deductions, the new tax law will mean a tax cut, meaning they can stretch their money further for the next few years. Lower tax rates could also impact a client's withdrawal strategy, perhaps allowing them to withdraw more money or modify their mix of withdrawals from different types of accounts. For instance, a client who was withdrawing from taxable accounts up to the 15% tax rate might have more room to withdraw now, as the rates were dropped and the ranges extended.
For some clients who were itemizing, the tax bill could result in an increase in taxes. This is more likely for seniors living in states with high income and property taxes, like New York, New Jersey, California, Massachusetts and Connecticut. We could see this change motivate older clients who are not tied down to relocate due to the new annual $10,000 cap on the state and local tax (SALT) deduction.
Ultimately, the tax reform bill left retirement planning mostly untouched from a legal standpoint. However, the tax bill will still have a major impact on retirement savings, income levels and taxes. Not all retirees will feel the changes equally from the tax bill. Some will benefit more than others.
Despite all the uncertainties, one thing is clear. The Tax Cuts and Jobs Act of 2017 highlights the need for quality financial planning and retirement planning, and the important roles of financial advisers and tax professionals.
Jamie Hopkins is a professor of tax at The American College's Retirement Income Certified Professional program. Follow him on Twitter @RetirementRisks.