With the 2016 presidential election completed, it’s time to start looking ahead to the coming year and focusing on changes that impact investment and financial planning decisions.
Both Trump and House Speaker Paul Ryan have proposed tax reform plans that envision reducing personal income and corporate tax rates.
Both plans promise the lowest tax rates since WWII, and personal income tax brackets would be reduced from seven to three. Under Trump’s plan, the tax brackets would be 12%, 25% and 33%, a reduction from the existing highest rate of 39.6%. Capital gains rates would remain at a top rate of 20%, while business income would be taxed at 15%. Both the Trump and Ryan plans would raise the standard deduction limit for individuals.
Overall, lower personal and business taxes are anticipated across the board. For individuals thinking about making IRA and/or pension contributions, the question is whether they should be made pre-tax or Roth. A pre-tax or 401(k) contribution offers a current income tax deduction for the amount contributed, but will result in income tax on income taken out of the account. A Roth IRA or Roth 401(k) contribution is made with after tax funds, and will result in tax-free income later provided specific conditions are met. A Roth IRA does have an income limit of $194,000 for a married couple filing jointly.
In determining whether to make a pre-tax or Roth contribution, the key is to look at the financial impact a deduction would have on tax liability. Take the example of an individual earning $40,000 per year. Under the Trump plan, the tax burden would be $4800, compared to a 25% tax rate in 2016.
The general thinking goes that if there is less tax to pay then taking a tax deduction would have less of a financial impact than in a higher tax environment, For example, if an individual earns $40,000 in annual income, under the Trump tax plan he or she would be subject to $4800 in taxes, versus a 25% income tax rate in 2016. An IRA contribution deduction would reduce income tax due, but the deduction would have a lower financial impact than there would be with higher tax rates, making the Roth contribution more attractive. A lower income tax policy is likely to lead to more advisors recommending the Roth IRA or 401(k) option over a pre-tax contribution. Lower tax rates mean that deductions carry less value.
Some might suggest that lower tax rates means that saving money in a tax free retirement account, such as a Roth, would have less value given that there would be less tax due at distribution. But with tax rates at probably historical lows, those looking to retire in the next 10-20 years could be looking at a future with higher taxes.
For more information, please read:
Why The Roth IRA May Be Big Winner In 2016 Presidential Election | Forbes