Ready or not, here comes tax reform.
After being rebuffed at seemingly every turn by members within his own party with regard to healthcare reform, President Trump and lawmakers in Washington have finally turned their undivided attention to reforming the U.S. tax code for individuals and corporations. In September, President Trump laid out a skeleton outline of some of the changes that could be coming. This includes a very important drop in the peak corporate income tax rate to 20% from 35%, which is expected to put more money in the pockets of businesses to hire and boost wages, as well as a simplification of the individual tax code.
The current tax schedule for individual taxpayers consists of seven progressive brackets ranging from a low of 10% to a peak of 39.6%. Under Trump's plan, we'd see a decrease in the number of tax brackets, an expected decline in the effective tax rate for most American workers, and a major reduction in the number of available credits and deductions. In return, the average American would see his or her standard deduction roughly double.
Republican ideas to bridge a $1.5 trillion long-term shortfall aren't very popular
While this tax reform plan is designed to stimulate economic growth to a sustainable 3% annual level, it comes with a price. Reducing the corporate income-tax rate could reduce federal revenue by $1.5 trillion over the next decade, which is often described as the "long-term" in most projections. That money has to be made up somewhere, and cost-cutting simply won't bridge the entirety of the shortfall. In order to counter this lost revenue, the GOP has been tossing around a number of unpopular ideas.
For instance, the Los Angeles Times reported in August that Republicans had considered narrowing down who qualifies for the highly coveted mortgage interest deduction. Currently, homeowners are allowed to deduct the interest they pay on their mortgages, up to $1 million in mortgage debt. The GOP had considered lowering this threshold to $500,000. The Tax Policy Center believes such a move would result in 0.8% of tax filers paying an average of $3,100 more a year in federal income tax.
Employer-sponsored 401(k)s have been another commonly touted revenue shortfall solution. One such plan suggested "Roth-ifying" the 401(k). The way a 401(k) works right now is that before-tax money is contributed and allowed to grow on a tax-deferred basis. When you reach the eligible age to begin making withdrawals, only then do you pay ordinary income tax on what you withdraw. With a Roth IRA, you contribute after-tax money and, assuming you stick to the withdrawal eligibility rules, never owe federal tax again, regardless of how much or little you withdraw. With the federal government needing money, Politico has reported that the GOP has considered making the 401(k) an after-tax-funded investment vehicle, which would allow it to collect tax revenue up front.
A more recent GOP plan which has gained a lot of negative buzz suggests that some party members have considered slashing the annual contribution limit to 401(k)s. The Internal Revenue Service recently announced a $500 increase in the annual contribution limits for workers under the age of 50 to $18,500 in 2018. However, rumblings on Capitol Hill imply that this annual limit could be cut to just $2,400. Such a move would ensure that more earned income is exposed to federal taxation each year, providing the federal government with much needed capital. Of course, it could also significantly discourage saving, and remove one of the dangling carrots employers used to help retain talent.
Trump says no to 401(k) reforms, but he's flip-flopped on retirement issues before
As of March 2017, roughly 55 million working Americans have in excess of $5 trillion invested in 401(k)s. Could the GOP really be coming for America's most important retirement tool? Not if President Trump has anything to say about it.
On Oct. 23, 2017, Trump sent out the following tweet:
There will be NO change to your 401(k). This has always been a great and popular middle class tax break that works, and it stays!— Donald J. Trump (@realDonaldTrump) October 23, 2017
There's no sugarcoating the language or message here. Trump wants retirement plan changes left off the table for tax reform, which is a message he reiterated on numerous occasions throughout his campaign. In speaking with reporters last week, Trump said, "401(ks)s are very important," and suggested that while House Ways and Means Committee Chairman Kevin Brady (R-Tx.) was doing a fantastic job in working out the details of tax reform, he'd be unwise to pursue changes to the tax treatment of retirement plans.
While this might seem like a pretty clear line in the sand that the president has drawn, we have to remember that he's already broken a promise made to retirees less than a year after taking office. Despite repeated pledges not to touch so-called entitlement programs like Social Security and Medicare, Trump's initial budget proposal, released earlier this year, called for a $72 billion cut to Social Security's Disability Insurance (DI) Trust over the next decade. This worked out to a 4% overall decline in payouts for the DI Trust over a 10-year period.
Trump's budget director Mick Mulvaney did his best to take heat off of the president's proposal by pointing out the smaller role disability insurance payments have next to say retired worker benefits. Nevertheless, it doesn't mask the fact that this proposal broke Trump's previous promise not to alter retirement plans like Social Security.
Trump will be further challenged by rifts between members of the Republican Party, as well as disagreements that he's had with members of his own party. Senate Finance Committee Chairman Orrin Hatch (R-Ut.) is opposed to Trump's view of protecting 401(k)s. Hatch, who's been highly influential in the creation of tax legislation throughout the years, opined that he doesn't feel any pressure from the White House when formulating a tax plan, but that he remains "open-minded about it."
Where do we go from here?
So, what does this mean for the 55 million Americans currently taking advantage of a 401(k)? For now, staying the course is the most prudent form of action. Nothing changes until tax reform is signed into law, and thus far this Congress hasn't been able to pass any major legislation. Even if this Congress is able to pass tax reforms, there's no guarantee that adjustments to 401(k)s or other retirement plans will be included in the bill. You'll simply have to watch and wait to see what unfolds while sticking firmly to your investment game plan in the meantime.