Tax Laws Changing and How Clients See Funds Available for Retirement

Recharacterization allowed for wiggle room in planning and may have a significant impact on investors. Financial advisors should educate clients about the need to review any conversion that was made with the intent to correct it later by recharacterization.

Retirees may be the group that stands to gain the most from Congress’s massive 2017 tax overhaul. And the talk among those closer to retirement may be positive. But for folks in their middle years, the tax bill’s changes may seem overwhelming. News reports seemed to focus more on how tax deductions (mortgages and charitable donation deductions, for example) were removed, and less on the increased standard deduction.  But those news reports may have failed to note that the increasing number of workers being shifted to freelance or consulting status (called the “gig economy”) will be closer to one third of the workforce in twenty years. The impact of that shift is that more folks will want those deductions than ever. So what else are clients hearing about the tax laws changing?

First, if clients think that their taxes are increasing, they may fear that they have less to contribute to retirement. So what changes impact the amounts available for retirement savings? There is now an expanded deduction for medical expenses. In past years, to deduct medical expenses from income, the medical expenses had to reach 10% of adjusted gross income. Under the new rules, those expenses need to reach only 7.5%.  This is a significant amount for those seniors with serious health issues. Also vital, is that the new tax law eliminated he deduction of investment management fees. While Congress debated changing the rules on 401(k)s, they did leave those rules alone. Congress also debated changing the rules on the so-called Stretch IRA – that allows heirs to spread payments from an inherited IRA out over their lifetime so as to reduce the tax impact. In the end, the plan to change the Stretch IRA also was abandoned.

The change to mortgage deductions may be the most significant of all of the changes as investors may see that change the most often. That is, they may be reminded of that change with each month’s mortgage payment. Since this portion of the law seemed unclear, the IRS responded to questions via its website. There it stated: “that despite newly-enacted restrictions on home mortgages, taxpayers can often still deduct interest on a home equity loan, home equity line of credit (HELOC) or second mortgage, regardless of how the loan is labeled…. [the new tax law] suspends from 2018 until 2026 the deduction for interest paid on home equity loans and lines of credit, unless they are used to buy, build or substantially improve the taxpayer’s home that secures the loan.” Clearly, investors should seek the advice of tax professionals. However, they may also feel as though their options to refinance mortgages to help pay for college, for example, or other expenses are now limited by the change in the law.

While the tax on capital gains was debated hotly, the end result was that the tax on short term capital gains became slightly smaller than before, while long term capital gains remained the same. Tax treatment of contributions to 401(k)s remained the same as well.

As for IRAs, the traditional tax treatment stayed the same, but importantly, the ability to convert a traditional IRA or 401(k) into a Roth IRA and then undo that conversion through a recharacterization is no longer available. This predominantly effects those investors who expected to be in a higher tax bracket while in retirement, as withdrawal from an Roth IRA would have better tax treatment. Where something changes in those investor’s lives, like a health issue, converting back into the standard would have been beneficial. This weird quirk probably missed most of the media, since it would have required knowledge of tax law and the ability to read past the third paragraph of any article, but could be vital to some investors who may have already converted assets. Recharacterization allowed for wiggle room in planning and may have a significant impact on investors, yet, they may not ne aware of the impact yet. Certainly financial advisors should be clear on educating clients and employees about the need to review any conversion that was made with the intent to correct it later by recharacterization.

Other well discussed elements of the new tax law include the extension of time to repay loans from 401(k) plans – from 60 days after separation from employment to the date taxes are due on the tax year of separation.

Other not well discussed elements include changes to the ability of investors to use IRA withdrawals for disaster relief. The new law allows those who used IRA withdrawals for qualified disaster relief uses on their residence to book that income over three years.

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