One of the Trump Administration’s most highly-awaited proposals is the one for tax reform. As with any reform proposal, the devil is in the details, but some of the first proposals sound good on their face. As anyone who has ever had to file taxes understands, the tax code is in serious need of reform. And while previous proposals may have had severe drawbacks, the latest proposal has many features that could end up benefiting taxpayers and investors.
Eliminating Itemized Deductions
One of the major changes that the tax reform proposal seeks to make is eliminating most tax deductions. The only ones that would remain would be the deduction for mortgage interest and the deduction for charitable contributions. The deduction for state and local taxes would be done away with, although opposition to getting rid of that deduction may result in the deduction being kept.
According to the most recent data, only about 30% of tax filers itemize their deductions – the rest take the standard deduction. While there are many different expenses that can be itemized and deducted from taxes, the four most often claimed deductions are for state and local income and sales taxes, mortgage interest, charitable donations, and real estate taxes.
Itemizing varies greatly by income level. Only 5% of those whose adjusted gross income (AGI) is under $20,000 itemize. That rises to 17% for those making between $20,000 and $50,000; 46% for those making $50,000 to $100,000; 77% for those making between $100,000 and $200,000; and peaks at 93% for those making $200,000 to $500,000. The average sum of itemized deductions for those making under $500,000 ranges from just under $16,000 for those making under $50,000 to $43,000 for those making $200,000-500,000.
It really only makes sense to itemize deductions if the amount itemized is greater than the standard deduction, which for 2017 will be $6350 for single people, $12,700 for married couples filing jointly, and $9,350 for heads of households. The amount of record keeping that is required to itemize deductions, keeping records over the course of the year and then filing that information with IRS, can take many hours for taxpayers to perform.
The Trump tax plan would nearly double the standard deduction, to $12,000 for single people and $24,000 for couples filing jointly. For most households that deduction would be so large that it would make itemizing no longer worth the time and effort, even for those with mortgage interest. That right there would cut down on a significant tax burden for millions of American families.
Simplifying Tax Brackets
The new tax proposal simplifies tax brackets by collapsing the current seven brackets down to three brackets: 12%, 25%, and 35%. It’s not yet certain what the income levels will be for each of those brackets. Some people in the current 10%, 28%, or 33% tax brackets could see themselves pushed into a higher bracket, although the doubling of the standard deduction is calculated to eliminate any additional tax they might have to pay as a result. At any rate, simplifying tax brackets would make it easier for many households to calculate the tax consequences of raises, bonuses, or any unexpected additional income.
Eliminate the Alternative Minimum Tax
The alternative minimum tax (AMT) was introduced in 1969 in response to reports that 155 high-income households had taken advantage of so many benefits and deductions that they paid no federal income taxes. The AMT was supposed to ensure that those high earners would no longer be able to take advantage of loopholes to avoid paying federal taxes.
Because the income threshold for the AMT was never indexed to inflation, over time it ensnared more and more middle-class households. Nearly four million households have to pay the AMT each year, but nearly 10 million households have to do the calculations to see whether they are required to pay the AMT. The Trump proposal eliminates the AMT completely.
Territorial vs. Worldwide Taxation
The Trump plan also advocates a territorial tax system that would only tax income earned in the United States. Most of the discussion surrounding the territorial tax system has only pertained to corporate income, but implementing a territorial tax system would also help US citizens living and working abroad. The US system of worldwide taxation has helped make American citizens financial pariahs overseas, forcing more and more to give up their citizenship in order to escape double taxation.
Lower Corporate Taxes
The Trump plan lowers the maximum corporate tax rate from 35 percent to 20 percent and lowers the maximum tax rate for small businesses to 25 percent. While many large corporations already pay effective rates lower than that due to loopholes they exploit, that requires large legal teams working non-stop to figure out how to reduce companies’ tax burdens. Dropping the tax rate reduces the incentive to exploit every loophole, making it easier and less costly not only for established corporations to do business but also for small corporations looking to get a foothold.
In the case of public corporations, lower taxes means greater income, which means more money able to be passed on to stockholders. That’s great news for anyone who invests in stocks. In a market that looks set to start declining due to the Federal Reserve’s impending monetary tightening, anything that can buoy stock prices should be welcomed.
Areas of Caution
There’s always a large amount of horse trading that goes on with any sort of legislative proposals, so the final details of any tax reform may look drastically different from the initial proposals. Investors should pay particular attention to proposals that affect retirement accounts. Some early chatter even mentioned that there have been discussions about taxing 401(k) contributions in order to “pay for” other tax cuts.
Many millions of Americans have benefited from the current tax treatment of 401(k) and IRA accounts. Being allowed to use pre-tax dollars to fund those accounts makes it far easier for most households to save for their retirement. Whether they’re investing in stocks and bonds or holding a gold IRA, the ability to defer taxes on contributions has played a vital role in building up to Americans’ retirement assets and shouldn’t be used as a bargaining chip.