As we sit on the eve of Donald Trump’s presidential inauguration, there are many questions about the direction President Trump will take on different issues and policies. Many of these questions are coming from the financial services industry and while much of the talk has centered on the fate of the DOL fiduciary rule, other proposed changes may also affect advisors and their clients.
One such change is President-elect Trump’s tax plan. The biggest change is a proposed restructuring of the seven current tax brackets, reducing them down to three: 10, 20, and 25 percent. Now we will see President-elect Trump implement his tax policies with a goal of reducing the top marginal tax bracket from 39.6% to 25% (which would represent a 37% reduction in the tax rate for those in this tax bracket). One question that arises is whether restructuring the tax brackets will impact savings in tax advantaged accounts. Will saving in these accounts be less attractive to retirement savers?
People saving for retirement must keep in mind that Roth accounts are more attractive when the saver’s top marginal tax bracket is lower today than it is projected to be at distribution. Under President-elect Trump’s plan, Roth contributions become more attractive than pre-tax contributions.
Retirees who are taking distributions and have lower tax brackets today than they anticipate in the future may want to focus on taking distributions from pre-tax savings, leaving Roth accounts for later years in which tax brackets will likely increase. (Deciding which account to take distributions from depends on additional factors such as relative allocations between accounts and where income falls in the tax brackets.)
If President-Elect Trump gets his way and the top marginal tax bracket becomes 25%, Roth contributions will be very attractive for most high-income earners. A few items come into play here.
First, in most situations, it makes sense to have significant pre-tax assets during retirement. This is because for taxation in retirement elective distributions occur after the annual fixed income (such as payments from Social Security and pension plans). After the fixed income distributions most people will be in the lower tax brackets. Having pre-tax income in the lower tax brackets can keep taxation low.
Second, itemized deductions may be phased out because of earnings. If a client’s taxable income falls within (or just above) the phase-out range of the itemized deductions, then pre-tax contributions may reduce their taxable income, thereby putting some (or all) of their itemized deductions back into play.
Speaking of deductions, another probable change will be to cap itemized deductions. President-elect Trump has not provided details on his proposal to cap itemized deductions. That leaves a lot of questions on the table, but once the rules are introduced, those who have taxable earnings inside of (or just above) the phase-out window can get an extra benefit by making pre-tax contributions to their retirement plans. (They may be able to reap similar benefits by taking other actions to reduce their gross earnings, perhaps by increasing charitable giving which President-elect Trump has indicated he will not cap.)
Financial advisors will be waiting expectantly to see what transpires as any of these proposed changes may necessitate different retirement strategies for clients. Stay tuned to our blog for updated analysis on today’s important financial issues. You can also read my article in Financial Planning Magazine, “3 Social Security questions for the Trump era” for my thoughts on Social Security.