How the Tax Changes Affect Retirees and Pre-Retirees

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The new tax laws have some far-reaching implications for retirees and pre-retirees. Joining me to discuss some of them is Tim Steffen. He is director of Advance Planning for Baird in Milwaukee.

Tim, thank you so much for being here.

Tim Steffen: Thanks for having me, Christine.

Benz: I'd like to focus today specifically on the implications of the new tax legislation for retirees. Let's start with the headline news, which is that we have these much larger standard deduction amounts. Do you think that they will do away with a lot of taxpayers itemizing their deductions?

Steffen: No question. A lot fewer people are going to be itemizing deductions. I have seen low-single-digits or low 10s and 20s of people who are going to be itemizing, much fewer people than in the past have been itemizing. From a tax preparation standpoint, document retention standpoint, it should make things a lot easier for all taxpayers.

For those approaching or in retirement even more so, because they were less likely to be itemizing anyways, because they didn't have maybe some of the traditional deductions that the working people …

Benz: The big mortgage interest deduction.

Steffen: Correct. They were more likely to take the standard anyway. The largest standard deduction could be a real boon for some of them.

Benz: I know that you have talked about this idea of bunching deductions, using the standard deduction in some years and saving your itemized deductions for other years. Can you just sort of talk in general terms about how that would work?

Steffen: With the larger standard deduction you're still going to have some of those expenses you incurred during the year that are considered deductible but aren't big enough to get you over the threshold. Instead of bumping up right up to it every year and never really getting the benefit of those expenses, you try to bunch them into one calendar year. We have talked about this technique for a long time regarding medical expenses, because there's always been that AGI threshold that a lot of people can't get over.

Benz: Let's talk about it. It's an adjusted gross income threshold. We are actually seeing some changes there with this new tax law that reach back to 2017. Let's talk about what's going on there.

Steffen: On the medical expense side, there have always been an AGI threshold. Your expenses had been more than a certain percent of your AGI before they become deductible.

Benz: Your adjusted gross income.

Steffen: Adjusted gross income. For a long time that was 7.5%. Now, under the healthcare act, that's changed to 10%, although there was some grandfathering that was built in. In 2017, that was supposed to be 10% for everyone. Under the new tax law now it's 7.5% for everyone for 2017 and 2018 and then in 2019, it's supposed go back to the 10% for everybody.

You've got this couple of year window where it will frankly be easier to claim medical expenses than what has been in recent history. This idea of bunching, trying to bunch as many medical expenses in a one year as you can to get yourself over that threshold.

Benz: If you have elective procedures, for example?

Steffen: It's a great idea and concept, but it's harder to implement because you don't always know what your expenses are going to be.

Benz: And you don't always have control over when you would have medical procedures.

Steffen: You are looking at things more on the margin like refiling prescriptions, eyeglasses, dental visits, that kind of thing, or elective things, as you said, trying to get those all in one year.

Benz: Let's talk about what's going on with the state and local taxes as well as property taxes. This has been really in the news, but let's talk about what is going on in terms of itemized deductions and these costs.

Steffen: For 2017, you are able to take a full tax deduction for all of your state income taxes. If you're in a state that doesn't charge an income tax, you could deduct your sales tax and then also any property taxes you were paying in your home or even in states that charge a personal property tax. Those are all fully deductible in 2017.

In 2018, they are still deductible but the cap on all of those expenses combined is $10,000. That applies whether you are single or married, which is one of the things that got some people concerned about is, same cap for singles and marrieds. But it's $10,000.

A lot of people are going to get over that pretty easily between their state income, just paying the state income tax alone, and then you put property tax on top of that. A lot of people are going to be finding that expenses that they would have deducted in 2017 aren't going to be deductible anymore.

Benz: One thought is, people who maybe have more than one residence in two states or people who are considering relocating in retirement, let's talk about how that cap on state and local and property taxes might affect decision-making there.

Steffen: The people who are most negatively impacted by this change and the people with multiple residences where they are paying property taxes of multiple homes or who lived in the high-tax states, the New York, California, New Jersey …

Benz: I'd add Illinois to the mix.

Steffen: Illinois would claim to be there, yeah, Minnesota, Iowa, there are some Midwestern states that are high-tax states, too. Those residents are going to start running into limitations on their deductions. They may have already been having some issues with that because of the AMT which is a separate issue, but that may have been liming some of their state tax …

Benz: Alternative minimum tax.

Steffen: Correct. The alternative minimum tax might have been limiting their deductions in the past. But now, it's a hard cap on those dollar amounts. Whether they are in AMT or not, they are going to run into problems with deducting that.

It frankly becomes more expensive to have multiple homes. It becomes more expensive to live in some of those high-tax states. Now you start thinking, well, what can I do to minimize that expense. You start considering relocating, maybe to a no-tax state. There are seven of them out there that don't charge any income tax, a couple of others that are very low, and then others that are, the rest of the states that are kind of more in that middle road of income taxes.

Benz: There are a lot of different dimensions to deciding whether to relocate, family considerations and everything else, but taxes are certainly in the mix.

Steffen: Absolutely.

Benz: Let's talk about what's going on with mortgage interest. I mentioned that many retirees do not have mortgages, but many retirees are in fact carrying mortgages into retirement. Let's talk about what's going on with the deductibility of mortgage interests.

Steffen: What they do with the interest deductibility is there are a lot of changes being discussed that didn't happen, but the ones that did happen were, one, they capped the deduction on new mortgages to $750,000 of debt. The previous rule had been $1 million of debt. That rule, any existing mortgages were grandfathered. If you had a mortgage of over $750,000, you can continue to deduct the interest on that up to $1 million of debt. It's the new homes where you are going to be capped. Or let's say, you have a home and maybe you are thinking about buying a second home, and that new home had a mortgage of $600,000. Well, now--the original home had a $600,000 mortgage. Now, the new home, you can only take up another $150,000 of debt and be deductible. Any debt over that you would not be able to deduct the interest on that portion of the mortgage.

For those who already have two homes and their mortgage is on them, they are fine. But if you are thinking about acquiring a second home, or relocating or something like that to maybe a bigger home, you got to be aware of what these new deduction limits are going to be.

Benz: Another dimension, of course, is this higher standard deduction which may be larger than the amount that you are able to amass with your total itemized deductions?

Steffen: Right. There's less interest you can deduct, plus it's going to be harder to deduct with the now larger standard deduction.

Benz: Home equity loans, also, the interest under the new laws will no longer be deductible, correct?

Steffen: Correct. In general, home equity loan interest is not going to be deductible. It really depends on what you use the loan for. A lot of people use it to buy car, a vacation or something like that. That interest will no longer be deductible. If you use it to build, acquire, or substantially improve your existing home, then the interest would still be deductible. But that's not the typical use of home equity loans.

Benz: How about to do sort of basic maintenance and repairs like new roof, new furnace, etc.?

Steffen: The rule is, substantially improve. There's some gray area there.

Benz: You can't just replace the furnace though, doesn't it sound like …

Steffen: I would say it's not for repainting or recarpeting, but maybe a roof might be substantial. Relandscaping the house might be something like that. There's interpretation to be had there.

Benz: Let's talk about all of the things that aren't changing for retirees and pre-retirees. On the retirement savings front, a lot of things that we had been hearing might happen didn't actually come to pass in the final legislation.

Steffen: Right. There is a lot of talk leading up to it and throughout the fall and early into November even there was going to be reductions in the amount you can put into your retirement plans, limiting the deductibility of those, this whole idea of Rothification …

Benz: Right. That everyone would have to do Roth. Company retirement plan contributions.

Steffen: Correct. Yeah, no deduction for the contributions, but when you took it out, it would be tax-free. None of that ended up coming to pass. All the rules you are used to dealing with when it comes to saving for retirement are basically the same as they were before.

Benz: One though that I want to touch on, Tim, is this idea of being able to do a do-over on your conversion from a traditional IRA to a Roth. That recharacterization is going away starting in 2018?

Steffen: It used to be that if you did a Roth conversion, you had until Oct.15 of the year after the year of the conversion to change your mind and recharacterize it back. That recharacterization opportunity has gone away. There is a little uncertainty as to whether that only applies to 2018 conversions or if it goes back to 2017 conversions that weren't recharacterized before the end of the year. I think most people are landing on those are now no longer allowed either. But regardless, if you do a Roth conversion going forward, you got to be prepared to leave it in there, because there is no opportunity going forward to undo it.

Benz: You better be sure. How about the idea of doing multiple conversions as a way to kind of …

Steffen: Test it out.

Benz: Yeah, test it out.

Steffen: You don't have to do one conversion during the year. You can do one at the beginning of the year and then if you are comfortable, maybe do another one later on. You can spread them out through the course of the year. From a tax standpoint, it doesn't change it. It's still the same amount of income tax, but you are not making the big commitment upfront.

Benz: You could also do the conversions over multiple years, right?

Steffen: Absolutely, yeah. You can do it as many as you want over as longer time period as you want. And there is no income threshold. Anybody can do them.

Benz: And finally, the thing I want to touch on is, if someone happens to make the wrong type of IRA contribution, it sounds like that type of mistake would be able to reversed?

Steffen: Correct. If you put money into a Roth and it turns out you are not eligible to, one of the original proposals said, no, you can't recharacterize that either. That was a bad call and they fixed that. So, now, if you are making a contribution to a Roth and it turns out you are not, you can recharacterize that. It's the conversions you have to be more careful with.

Benz: Tim, helpful recap. Thank you so much for being here.

Steffen: Thanks, Christine.

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