- House Republicans released a tax proposal, another step in the tax reform process, but still far from a final change in tax law.
- The proposal calls for new individual, corporate, and pass-through tax rates.
- Contribution limits and tax treatment for major retirement accounts remain unchanged, but the proposal would significantly change many other deductions.
House Republicans released a proposed tax plan that offers the first detailed look at the most ambitious tax reform proposal since 1986. The plan calls for changes to income tax rates, estate taxes, deductions, and some retirement rules—and if even parts of the proposal become law it would be a significant event for investors.
“The House proposal is sweeping, and could mean major changes for businesses and individuals,” says Jim Febeo, senior vice president in Fidelity’s government relations team. “While this is a major step, the proposal is far from finished law. Investors should be cautious about making planning decisions based on a proposal, and in general should not make investing decisions based primarily on tax law.”
Adjusted tax brackets
The tax proposal includes changes to the income tax brackets. The new proposed system would reduce the number of brackets from 7 to 4, and raise the maximum income limits for the lower brackets, while retaining the same top tax rate.
New corporate tax rate and pass-through tax rate
Corporate tax rates would be cut to 20%, while businesses conducted as sole proprietorships, partnerships, and S-corporations would be taxed at a rate of 25%. However, professional services, like doctors, lawyers, accountants, designers, and consultants, wouldn’t qualify for the reduced rate.
Keeping retirement savings opportunities
The proposal made no change to the existing retirement savings incentives, preserving the favorable tax treatment and contribution limits for 401(k)s, IRAs, and other retirement savings accounts. The proposal also left the rules for health savings accounts intact.
“We are pleased the House is supporting retirement savers by maintaining current pre-tax retirement savings incentives while considering other changes to the tax code that would enhance opportunities for investors, businesses, and all Americans saving for their financial futures,” says Febeo.
The proposal does call for ending the Roth IRA recharacterization option. Recharacterization allowed taxpayers to undo a Roth IRA conversion for a limited time, and was often useful if the value of the converted investments fell.
The phaseout of the federal estate tax
The proposal would double the federal estate tax exemption to $11 million per person ($22 million per couple), and remove the tax completely by 2024. Beneficiaries would still get a step up in basis, meaning there would be no capital gains tax due on inherited assets at the time of the transfer, and the cost basis—the value used to compute tax liability—would be reset at that date.
It is important to note that state level estate tax exemptions are often much lower than the federal level and are unaffected by this proposal.
“While further reduction in the estate tax will help some families avoid this tax at the federal level,” says Kevin Ruth, head of wealth planning and personal trust, “it remains important for all households to have a current estate plan that helps ensure their wishes are carried out and reduces the cost of transferring assets as part of an estate.”
The elimination of the alternative minimum tax (AMT)
The AMT was designed to prevent high-income individuals from avoiding income tax by piling up deductions. It is essentially a parallel method for calculating your income tax liability. The proposal eliminates this tax system.
New higher standard deduction
The proposal calls for the combination of the personal exemption and standard deduction into a single higher standard deduction of $12,200 per individual and $24,400 per family for 2018. The proposal calls for increasing the child tax credit from $1,000 to $1,600 and a new tax credit for other dependents of $300. Eligibility for a portion of this credit will not require that the filer pay taxes.
The plan also changes the balance between itemized and standard deductions. Higher standard deductions mean fewer people will qualify for itemized deductions—so deductions like charitable gifts, medical expenses, margin interest, and home mortgage interest will all face a higher threshold before they become useful.
In addition, the proposal directly changes or limits a large number of deductions and credits. Those changes include:
- Mortgage: The deduction would be limited to $500,000 worth of debt instead of the $1 million today, and restricted to the primary residence—taxpayers would no longer be able to deduct mortgage interest for a second home. (Note: For existing mortgages or purchases under contract prior to November 2, the existing rules would still apply.)
- State and local tax deduction: The deduction for state and local property tax would be capped at $10,000 and no deduction would be permitted for state and local sales tax.
- Medical expense deduction: The proposal would repeal the medical expense deduction.
- Adoption expense tax credit: This would be eliminated.
- Electric vehicle tax credit: This would be eliminated.
Changes in education incentives
The House proposal would overhaul the credits and incentives for education. First, it would eliminate the Hope Scholarship, Lifetime Learning Credit, and deduction for qualified expenses, consolidating them all in the American Opportunity Tax Credit.
No new contributions would be permitted to Coverdell accounts; instead, those accounts could be rolled into 529 plans, which could be used for elementary and high school expenses, in addition to qualified higher education expenses.
The student loan interest deduction and the exclusion of interest paid upon the redemption of eligible U.S. savings bonds for higher education (EE and I bonds issued after 1989), would also be repealed.
Less flexible rules for home sales
Homeowners have benefitted from rules that shelter capital gains on a primary residence. A married couple filing jointly could realize up to $500,000 in capital gains without taxation, if they had lived in the home for 2 of the previous 5 years. The proposal would limit this tax benefit to usage once every 5 years, and require residence for 5 of the previous 8 years.
The bottom line
The tax reform process took a major step with the release of this detailed proposal. But it is still far from a finished product. Investors should remember the fundamentals of tax planning and consider taking advantage of deductions, such as charitable giving, this year. But the story is far from complete, so be cautious making decisions based on a proposal. Consult a Fidelity advisor to discuss your strategy and consult a tax professional regarding your personal situation.