Investors' Plans May Face Changes as Tax Bill Looms

Note: The House bill as drafted would not make changes to capital gains tax brackets. This bill sets the cap gain rates at specific dollar amounts, rather than tying them to the rate brackets as the code says today. We regret the error.

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Congress is still wrestling with the specifics of tax reform, but it's not too early for investors to consider the potential implications for their plans. Joining me to discuss this topic is Tim Steffen. He's director of advanced planning for Baird Private Wealth Management.

Tim, thank you so much for being here.

Tim Steffen: Nice to see you again.

Benz: Tim, there's so much that we don't know. The Senate is still to come out with its tax reform package, and we'll have to see how these two things fit together, but we did get some details on the House package last week. I wanted to talk about that. You've done a helpful explainer, overall, about all the different implications, but I wanted to focus specifically on the investment piece. Starting with capital gains and losses, investors might be wondering whether there are implications for how they should manage their capital gains and losses, going forward.

Steffen: This is a very comprehensive bill. It covers a lot of topics. On the capital gains side, one of the things that was pretty clear is there really wasn't a change on the capital gains side, at least not an explicit change. They're not lowering rates, they're not changing rates or doing anything on timelines or holding periods, or anything like that. So no explicit changes in the capital gains side.

One change that would be kind of a ripple effect of some of the other changes would be an increase in the 15% tax rates on gains. Right now, that would apply to married couples with income below about $470,000. With the increase in the top tax rate in the proposal, going from that $470,000 up to $1 million, you now have that extra range of long-term gains would be at 15%. Essentially, another half a million of gains that would be at 15%, as opposed to 20%.

On the margin, if you're getting to the end of the year and you're thinking about maybe realizing a gain, there's a possibility it could be taxed at a lower rate next year for those in the higher brackets.

Benz: You wrote in your piece, actually, that that old advice to accelerate deductions and defer income if you possibly can applies more than ever right now.

Steffen: It certainly does, although there's a lot of if-thens and buts about that because of the specific deductions, but with the possibility of marginal rates going down in 2018, pushing income into that year would make sense. Some of the changes on deductions, with the loss of a number of itemized deductions, it might make more sense to pull those into 2017.

Benz: Another component of the House bill, related to alternative minium tax would actually roll back the alternative minimum tax. We don't know whether that will actually be part of the Senate bill or whether it'll be part of the final tax law. Let's discuss the implications there for investors, people with incentive stock options, other people who have been affected by the AMT.

Steffen: The first thing would be pulling out of AMT is a big step toward simplification, which is always one of the priorities of this bill and this reform, it's to simplify the task. That would be a big advantage there. In terms of what it means from a taxable income standpoint, you mentioned incentive stock options. For those executives or employees of companies who are still receiving incentive options--and it's a smaller amount than we saw 10 years ago, even. It's gone down quite a bit--those in the past or under today's law, would only be taxable under the AMT rules. You get rid of AMT, you get rid of the tax on ISO. So those would be more of a tax-free benefit, like they were many years ago, before AMT became such an issue, like it has been recently. Those executives with ISOs would have the ability to--not just executives, but employees, in general--would have more opportunity to exercise those tax-free.

Benz: But, as you said, we're seeing a reduction in the incentive stock options.

Steffen: Yeah, they're not as prevalent as they used to be.

Benz: Let's talk about college savers. There were some big implications for them in the House bill.

Steffen: A couple of big changes on the college saving side. One is Coverdell accounts, which were always kind of the ugly stepchild when it came to college savings, those would be still allowed, you could still keep your Coverdell account, but they wouldn't allow future contributions to those. After 2017, you wouldn't be able to contribute to a Coverdell.

Benz: A lot of firms have stopped offering them all together.

Steffen: They just weren't all that common. They had a $2,000 maximum contribution, there were income thresholds, they had to be depleted by a certain age. They just weren't as favorable as the 529 plans. The big advantage that Coverdells always had was that they were the only way to save on a tax-deferred basis for K-12 expenses.

Benz: Exactly.

Steffen: As part of eliminating future Coverdell contributions, 529s would be expanded to allow for qualified withdrawals for K-12 expenses, albeit a $10,000 annual cap, but still something. So that would be the big change on the 529 side.

The other thing that they proposed on 529s, it's kind of an unusual one, but it might offer some folks some benefit, is you could now open a 529 for an unborn child. You have to be pregnant, you can't plan years in advance for these kind of things, but you could open a 529 for somebody who's not yet born, which, in some scenarios, might make some sense.

Benz: Let's talk about estate and gift tax. The limits for the estate and gift tax would go up, but, then, estate tax would eventually be repealed all together. Let's talk about that.

Steffen: The plan for 2018, right now, barring any change in law, would be that the estate tax exemption would go up to $5.6 million per spouse, so $11.2 for a married couple. The proposal, then, would be to double that, first off, going from $11.2 to $22.4 million for a married couple. That should cover the vast majority of people who are left paying estate tax, which is already a small pool of people to begin with. Now that will really shrink that pool. Then, the other thing would be that, beginning in 2024, I believe it is, that they would simply repeal the estate tax. For the next few years, we'd have an estate tax, but then it would go away.

The other thing about this, if you think back to about 15 years ago, the last time they tried to repeal estate tax, it was a "We're gonna repeal it, but then we're gonna repeal the repeal." It was a one-year period where there would have been no estate tax. This does not have that repeal the repeal, so this would be a permanent elimination of the estate tax, beginning in for deaths in 2024.

Benz: Again, there's a lot to be sorted out here.

Steffen: Correct. One other minor change related to that would be on the gift tax side. The gift tax would still exist. The generation-skipping tax would go away, but the gift tax would stay around, but they'd lower the rate from 40% to 35%. So a minor change there.

Benz: One point I always make on the gift tax, though, very few people will ever have to pay the gift tax in their lifetimes.

Steffen: Correct. A lot of people get concerned about that limitation. Right now, it's $14,000. It would go to $15,000 in 2018. People are very cautious about giving over that, but if you give over that, you just use up some of your lifetime exemption. If that really goes to $22.4 million, I think most people would be OK to give away a little extra, above the $14,000. They wouldn't have to worry about it.

Benz: One smaller thing I want to touch on is what's going on with IRAs. The ability to undo a conversion would go away, the recharacterization. Let's talk about about that and also who should ever look at doing recharacterization?

Steffen: Probably the biggest thing that happened on the retirement plan side is really what didn't happen, and that is resolve this talk about Rothification of 401(k) plans. None of that was in this bill. Now, we may still see it in the Senate, they could come back and surprise us, but, as it stands right now, no material changes to 401(k) plans or anything like that.

The one thing that would happen is remove the ability to re characterize a conversion to a Roth IRA. So what you'll see today is some people will do a Roth conversion, take money out of the traditional IRA, move it to the Roth, pay tax on it with the hope of having all the growth be tax-free in the future. Then, they may decide that they either didn't want to do it because the tax cost was too high or, perhaps, the account fell in value and rather than paying tax at the higher value at the time of the conversion, they would do a recharacterization--pull that money back into the IRA, wait a period of time, and then try it again later.

This proposal would remove the ability to do a recharacterization. You wouldn't be able to do that anymore. Basically, if you decide to do a conversion, you have to live with it, and you have to pay whatever tax is due as a result of that. This would eliminate that recharacterization.

Benz: So your advice is, if I'm looking at my account and I've done a conversion that I want to undo, even though this isn't yet final, maybe it's reason to kind of get on the stick and think about getting it done?

Steffen: Typically, under current rule, for a 2017 conversion hat you did anytime this year, you'd have until Oct. 15, 2018, to change your mind, and people sometimes wait that long. That's the final due date for your tax return. What we're suggesting is if you're thinking about doing that, you might want to do that recharacterization before the end of the year. Again, we don't know if this is going to become law or not. If it does, it likely wouldn't take effect until 2018. In fact, all these proposals would be 2018 items. But we may get into 2018 and find out that your deadline has already passed to do the recharacterization, so maybe you do at least part of the recharacterization and leave some out there that you are still uncertain about. But I wouldn't wait real long on this one.

Benz: Lots to digest here obviously. Thank you so much for being here to unpack it for us.

Steffen: Always, thanks.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.