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What Investors Need to Know About the Tax Bill

Harder to access deductions, changes to inflation adjustments, and challenges to small retirement plans are on Morningstar Director of Policy Research Aron Szapiro's radar.

Jeremy Glaser: For Morningstar I'm Jeremy Glaser. The tax reform bill is approaching the finish line. I'm here today with Aron Szapiro. He's our Director of Policy Research, to discuss where the bill goes from here, and also what it could mean for investors. Aron, thanks for joining me.

Aron Szapiro: Thanks so much for having me.

Jeremy Glaser: Let's start just with a quick overview of where we are and what your expectations of what will happen over this coming week.

Aron Szapiro: As you mentioned, the House and Senate have reconciled their two versions of the bills. They've made some compromises. They've largely followed the Senate version. We would expect two things. One fairly obvious, we would expect final passage into law pretty soon. There's some political reasons we'd expect that to happen probably this upcoming week. 

Then, and I think people forget about this, we'd expect a technical corrections bill. Every major piece of tax legislation, and this is certainly a major piece of tax legislation, needs to have a technical corrections bill. That sounds boring, but it's really meaningful to you if it's your technical correction that is being made.

I'll just give an example from the Pension Protection Act. There was some big questions about the tax treatment for employers that offered both defined benefit and defined contribution plans, what the combined or aggregate limits were. That was sorted out in a technical corrections bill, and I expect that kind of thing. So some pretty meaningful changes and clarifications to come down the road pretty soon after this.

Jeremy Glaser: Let's take a look at the major goals of tax reform and kind of how this bill addresses them. Can you walk through what they wanted to do and what actually was accomplished?

Aron Szapiro: I think there was sort of three big goals here. I'm going back to some of the material that's been out really for years, particularly the so-called Better Way plan out of the House. The first goal was reducing the corporate income tax rate. I think you'd have to say that that has been achieved. The corporate income tax rate falls to 21%. You also have new breaks for many pass through businesses with certain limits by industry and income. Another goal has been repealing the individual mandate in Obamacare, and that is in the final bill. Then finally, I think there's this bucket of sort of simplification, increasing incentives for work, trying to pursue a sort of textbook optimal tax policy. I think there you have to say the results are pretty mixed.

I think it would be very difficult to say that this bill is going to really simplify things. If anything, we're already ... I mean I spent, I hope others had a more fun weekend, I spent a lot of my weekend trying to game out the implications for some of these things. It does add some more complexity, and that's kind of a function of retaining a lot of the deductions but making them harder to access. I think that in turn means people are going to try to figure out different ways they can still lower their tax bills as much as they can. In terms of the kind of optimal tax policy, which suggest you want to have lower marginal rates and a broader base, I actually think that has been somewhat achieved because so many fewer people will be itemizing. There's still an awful lot of different kinds of tax benefits for different kinds of activities. First two goals I think you'd have to say they checked the box, and the simplification maybe not so much.

Jeremy Glaser: Let's take a look at the impact on just ordinary tax payers. It's obviously going to depend a lot on your individual situation, but big picture, what will this mean for most tax filers?

Aron Szapiro: One thing tax filers are going to have to ask themselves is do they believe that some of these benefits are really going to phase out. I think as probably most of our viewers already know, the way the math on this bill works is most of the individual provisions expire in 2025. That was done to fit within these arcane Senate reconciliation budget rules, but what you believe about what's going to happen in the future I think probably many of these things will ultimately be extended. That's been the experience in the past, but it does create some uncertainty.

Another thing that will affect every taxpayer is that they have shifted the way that brackets and other tax provisions are adjusted for inflation to use what's called a chain CPI. This is a measure of inflation that tries to account for people switching to different products if the price of one goes up. Bottom line is it grows slower than regular inflation measures in most circumstances. As a result, people's taxes will gradually be pushed up over time. Those are the effects for all tax payers. I think people will have to sort of ask themselves over the next couple of years the extent to which they believe some of these things will be made permanent.

We talk about death and taxes as being the two certainties in life, but it turns out taxes, at least what they're charged on and what you can deduct, is not that certain. A lot of people have made plans that are based on the tax code remaining in perpetuity and it hasn't. Here we have a situation where we know things are at least scheduled to expire. Those are going to be the important considerations for all tax payers.

Jeremy Glaser: You mentioned deductions earlier and how there will be a scaling back, at least harder to access deductions. What's in this final bill? What's happening particularly with the mortgage interest deduction?

Aron Szapiro: The mortgage interest deduction, like all deductions that aren't sort of above the line, that's the IRAs and student loan interest, those are going to be much harder to claim. The reason is that the standard deduction is doubled, and the state and local tax deduction is capped at $10,000. The mortgage deduction has been reduced to being based on a maximum loan of $750,000 down from $1 million today. What that does is it reduces the number of people ... I've seen various estimates out there, and there was some last minute changes that will bump this number up a bit, but it's going to dramatically reduce the number of people who can itemize their deductions, and thus get any benefit for their home mortgage interest or anything else, charitable contributions as well would be the other big one.

That's a pretty big change. Even people who are managing to itemize, they have to remember the real benefit to them is not the total value of their itemizations, it's the total value of their itemizations, let's say that's $30,000, minus the standard deduction multiplied by their marginal tax rate. So it's a much smaller benefit than it used to be. 

One thing I noticed is that this new cap on state and local deductions, $10,000 maximum per year. That's property tax and income tax, which was a compromise at the end. That cap is not indexed for inflation, which means the value of those state and local deductions is going to go down at the rate of inflation over time.

Of course all of these things expire at the end of 2025, and we snap back to the tax system we have right now. Although, the brackets and things for that system are also indexed to this new measure of inflation, so they'll be going up at a slower rate than inflation, thus raising people's taxes. I know that's a lot of moving parts, but the bottom line is all of these things kind of snap back in 2026, but with a less generous tax code for individuals.

Jeremy Glaser: Looking more closely at what this means for investors, there was some talk about FIFO rules and potentially the inability to pick tax lots and to manage capital gains. That provision didn't make the final bill here.

Aron Szapiro: It didn't, and that didn't really surprise a lot of us who have been following this because it didn't raise as much money as I think the authors of the provision had hoped, the way that it was scored by the nonpartisan joint committee on taxation, so that's out. I think that is probably a relief for small investors and a number of startups that have really focused on these kind of tax loss harvesting strategies that would have been much less valuable, much harder to implement.

I think another change for small investors, or ordinary investors, is with small retirement plans. Remember, pass through income, that's the way most business owners collect their income. They're not organized as C corporations with dividends and such. They're going to get a big tax break up front, but they don't get that tax break in retirement. If you play that out, that disincentivizes a small business owner from wanting to set up a retirement plan and then sweeping their employees into that plan because of the benefits he or she could personally realize.

Instead, what somebody might do is say well look, my taxes are lower right now than they're going to be in retirement because I have this pass through benefit, as a pass through business owner, so I don't really want the tax benefit right now when I'm going to have pay ordinary income taxes later. I'll just invest in a normal taxable brokerage account and hope that the maximum capital gains tax rate stays at 23% and change. You can work out the math and see there are a lot of scenarios where that may make sense, so that may disincentivizes people from investing through retirement plans and that may be a problem for people who work for businesses that are organized as pass throughs but don't collect their income as pass through income, that are ordinary employees. That's another I think more subtle, but probably meaningful effect.

Then there was a change to the recharacterization rules for Roth IRAs. That kind of cuts off a strategy people had used where things change over the course of a year. That's a big deal if you wanted to use it, but it's not broadly speaking a huge change the way that the first in first out would have been.

Jeremy Glaser: Finally, there's no change to capital gains or dividend tax rates. That is still the same table that we're using today.

Aron Szapiro: That's correct.

Jeremy Glaser: Well Aaron I really do appreciate you taking the time to break all of this down, and I'm sure we'll talk to you soon as we get the corrections and look at this bill as it's passed.

Aron Szapiro: Thanks so much.

Jeremy Glaser: From Morningstar I'm Jeremy Glaser, thanks for watching.