There's no question that taxes have become hideously complex, especially federal income taxes. President Trump has indicated that reforming the current income tax system is one of his priorities, and he's released a proposal to broadly define the ways in which he plans to change the current system. Here's how the new plan will change the way you pay your taxes.
1. Tax brackets
There are seven federal income tax brackets, ranging from 10% to 39.6%. These brackets are marginal rather than absolute: if you're in the 25% tax bracket, that doesn't mean that you pay exactly 25% of your income in taxes. It means that you pay taxes of 10% of the first part of your income, the part that falls in the 10% bracket; 15% of the income that falls in the 15% bracket; and 25% of the income that falls in the 25% bracket. The new tax proposal continues to use marginal tax brackets, but includes only three such brackets: 10%, 25%, and 35%. The proposal does not list the income levels for these brackets, so it's hard to say whether this change will increase or decrease tax rates.
2. Standard and itemized deductions
Right now, taxpayers have two major options when it comes to deductions. A taxpayer can choose to get the standard deduction, which for 2017 is $6,350 for single filers, $12,700 for married filing jointly, and $9,300 for head of household. Or a taxpayer can elect to itemize deductions, meaning that he claims certain specific deductions (including medical expenses, state and local taxes, charitable contributions, and mortgage interest) in lieu of the standard deduction. The tax reform proposal limits itemized deductions to mortgage interest and charitable contributions only and doubles the standard deduction. This means that far more taxpayers will end up choosing the standard deduction rather than itemizing; taxpayers who already use the standard deduction will see a significant decrease in their taxes, while those who itemize may see a tax increase as they lose some of their deductions.
3. Alternative Minimum Tax (AMT)
The Alternative Minimum Tax was introduced in 1979 to eliminate loopholes that allowed some high-income taxpayers to pay little or no income tax. In essence, the AMT requires high income taxpayers to calculate their taxes both under standard income tax rules and under AMT rules, then use whichever system produces the higher tax liability. In recent years, between 4 and 5 million taxpayers have been required to pay the AMT each year. The new tax proposal completely eliminates the AMT. This will somewhat simplify tax preparation for most taxpayers, since they won't be required to run the numbers to see if they qualify for the AMT. It will significantly decrease income taxes for anyone who would otherwise have been required to pay the AMT.
4. Federal estate tax
The estate tax is a federal tax charged on a deceased taxpayer's estate. It's essentially a tax on the right of the taxpayer to leave property to his heirs. Currently, the estate tax is triggered only when estates are in excess of $5 million. The new tax proposal eliminates the estate tax, which will have no effect on the vast majority of taxpayers but will reduce the tax burden for those with very high-value estates.
5. Net investment income tax (NIIT)
The net investment income tax is a 3.8% tax that applies to investment income such as interest, dividends, rental income, and so on. It applies to individuals who have investment income and a modified adjusted gross income of $200,000 (single or head of household), $250,000 (married filing jointly), or $125,000 (married filing separately). This tax took effect in 2013 and is used to fund the Affordable Care Act. The new tax reform proposal eliminates this tax; most taxpayers will not be affected, but high-income taxpayers will have a reduced tax burden.
6. Capital gains taxes
The current long-term capital gains tax rates range from 0% to 20% for most assets. However, gain from certain types of investments is taxed at a higher rate of 28%. This higher rate applies to gain from selling art and collectibles as well as qualified small business stock. The new tax proposal resets the top capital gains tax rate to 20%. This likely won't affect most taxpayers, since the majority of capital gains transactions were already capped at a 20% tax rate.
What to expect from here
President Trump's tax reform proposal is still in the earliest phases of the lawmaking process. We can expect to see a number of modifications and compromises during the process of getting this proposal through both houses and made into law. It's also unclear at this point whether tax reform will pass soon enough to affect the 2017 tax year. It would be safest not to count too heavily either on the current tax breaks that President Trump has indicated he plans to eliminate or on the new tax breaks that he hopes to implement.