The Republican leadership in Washington is in the middle of negotiating the most comprehensive revision of the tax code since 1986. If you haven’t been paying attention to this, you probably should. The impending tax reform will most likely have a meaningful impact on your financial life.
The GOP issued a statement on September 27 that outlined four principles for tax reform. Two of these objectives have direct bearing on individuals and families: First, they want to simplify the code; second, they want to give American workers a meaningful tax cut.
To simplify the tax code, the GOP is proposing to reduce the number of tax brackets from seven to three. (Technically, there could be a fourth because there is talk of a surcharge on wealthy Americans, though so far nobody has defined who the wealthy are.)
The Republican plan also aims to simplify the tax code by eliminating most itemized deductions in favor of a larger standard deduction. The only deductions that look likely to survive are those for home mortgage interest and charitable contributions.
While these two measures will go a long way toward simplifying the tax code, a host of other complexities remain. Paul Ryan’s goal that most Americans will be able to file their taxes on a postcard is probably not going to happen in the near-term.
The GOP’s second objective is to give a meaningful tax cut to the middle class. Opponents claim tax reform will mostly benefit the rich. As evidence, they note that the top federal bracket will drop from 39.6% to 35%. However, this argument fails to consider the impact of losing most itemized deductions, especially the deduction for state and local tax payments. Losing this deduction will hit upper income folks hard—especially in high tax states like California.
We can get a sense of how this will shake out by looking at data from the statistical analysis of tax returns performed every year by the IRS. The most recent analysis from 2014 shows that middle income families (households with adjusted gross incomes between $50,000 and $100,000) claimed an average of $19,200 in itemized deductions. The new higher standard deduction will give these families about $4,800 more in deductions than they currently get by itemizing and will translate into about $1,000 in tax savings.
Upper middle-class families, those with adjusted gross incomes between $100,000 and $200,000, claimed an average of $25,500 in itemized deductions in 2014, very close to the new standard deduction. These families won’t see much of a change in their taxes under tax reform.
However, as income levels increase beyond $200,000, the loss of itemized deductions starts to bite a little harder. The higher the income, the bigger the impact. In fact, based on my estimates, a California family with adjusted gross income of $450,000 will likely see their tax burden increase between $10,000 and $15,000. Most of that increase is attributable to the loss of the deduction for state income tax.
It should be noted that each individual’s tax situation is unique, so the potential impact of reforms may be very different for you. If you are wondering how tax reform will affect you, you should talk with your financial advisor or your tax preparation specialist.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to email@example.com.