If you are expecting a political assessment of the President’s tax proposal, change the channel. It is our job at Moneywatch Advisors to analyze policy changes, assess the impact on our clients and help them change strategies, if warranted. So, in that spirit, here is our initial assessment on the framework released this week.
The first principle of the tax proposal framework is to simplify the tax code. Hallelujah! As I completed the coursework in the Certified Financial Planner process and studied for the exam, it became crystal clear that the tax code is the proverbial camel – a horse made by committee. No sane person would ever build a tax system like this from scratch. Enter your own Congress joke here.
As part of the effort to simplify, the framework decreases the number of tax brackets – the percentage of tax one pays – from seven to three. They are proposed as 12%, 25% and 35%. What we don’t know yet is what amount of taxable income fits into each bracket. So, let’s examine how the proposal compares to current tax law.
Chandler and Monica earn a combined $125,000 in salary and each contribute 5% pre-tax to their employer’s retirement plan. For simplicity sake, we’ll ignore other pre-tax deductions like their pre-tax cost of their employer’s health insurance plan, and call their Adjusted Gross Income (AGI) $118,750. (Gross income minus their retirement contributions) Unlike our friends on TV, they have two children.
Under current law Monica and Chandler have a choice between subtracting the standard deduction of $12,700 from their AGI or itemizing deductions. As you can see below, their itemized deductions are more than their standard deduction, so they obviously deduct the larger amount:
- Mortgage interest deduction – $5,578 (Interest paid on their $200,000 house where they still owe $150,000)
- State and Local Income tax deduction – $9,797
- Property tax on their home – $2,000
- Charitable contributions – $1,000
- Total: $18,375 (clearly more than the standard deduction of $12,700)
In addition to their itemized deductions, Monica and Chandler are also allowed to deduct $4,050 each as personal exemptions plus dependent exemptions for each of the kids, for a total of $16,200.
Finally, their AGI of $118,750 minus their itemized deductions of $18,375 minus their personal exemptions of $16,200 equals Taxable Income of $84,175. Again, we don’t know yet what tax rate to apply to this, and that could make a huge difference between Monica and Chandler’s actual tax bill under current law and the proposal.
Under the President’s proposal Monica and Chandler’s tax computation does become simpler:
Although mortgage interest and charitable contributions are still allowable as itemized deductions, state and local income tax and property tax are not allowed. As a result, Chandler and Monica find their itemized deductions are lower than the proposed new standard deduction of $24,000, so they choose to use the lower, standard deduction. And, the personal and dependent exemptions have been rolled into the proposed standard deduction, so those aren’t deducted separately either.
Their AGI of $118,750 minus the standard deduction of $24,000 equals Taxable Income of $94,750. A much simpler calculation but a larger amount of taxable income, under this example.
Conclusion: There are currently more questions than answers as this proposal has not wound its way through the legislative process yet, but taxable income for Monica and Chandler is higher under the proposal than under current law – by $10,575. Yet, we don’t know the impact on what they will actually owe because the applicable tax rates haven’t not been released yet. Their actual tax bill could be lower, we don’t know. In addition, they may benefit from a higher Child Tax Credit beyond the current $1,000, as the framework refers this issue to Congress to work out the details. The framework also doesn’t mention capital gains rates or the treatment of dividends. These can be significant issues for those who have large amounts in taxable investment accounts.
While there is much left to be decided, those of us in Kentucky need to watch closely if the elimination of the deduction of state and local income tax as well as state property tax becomes law. For states with personal income tax, the elimination of these deductions can be impactful. As more details become clear, we will update this assessment.