President Trump plans to provide tax relief for middle class Americans and simplify the tax code. How could this new tax plan, outlined in his “Tax Reform That Will Make America Great Again,” impact financial advisors? What could it mean for your clients?
Let’s start with this example. What if there was no tax reform? A married couple with $50,000 in Social Security benefits could take up to roughly $17,750 from an IRA and still pay no federal income tax.
A married couple filing jointly in 2017 has a standard deduction and two personal exemptions plus an additional exemption for being over 65 that total up to $23,300. Once their adjusted gross income has exceeded the combined deductions and exemptions, each additional dollar of income that receives ordinary income tax treatment is taxed at the rates in the current brackets. Intuitively, one would expect that with $67,750 entering the household, the couple would be well in to taxable range. That is not so. The current provisional income calculation keeps the couple out of taxable range.
If you want help navigating Social Security and understanding the impacts of the provisional income calculation in the current tax system, our Social Security and Tax Clarity software can help.
As a refresher, provisional income is the first step in the calculation of how much of a Social Security benefit is treated as taxable ordinary income. There are five steps in the process:
- Provisional income — includes half of the Social Security benefits, plus all other taxable income, including dividends, realized interest, and realized capital gains, as well as non-taxable interest earnings, such as from municipal bonds.
- First threshold is 50% of benefit income or modified AGI in excess of $32,000. Subtract the first threshold (25.32) and multiply by .5.
- Second threshold is 85% of the benefit income or the amount from the first threshold plus 85 percent of modified AGI in excess of $44,000. Subtract the second threshold (34.44) and multiply by .35.
- Add the answers from steps 1, 2 and 3 together.
- Calculate and apply the maximum.
At this point, Trump has not outlined how he will handle AGI in his new tax plan. The real question is whether the Trump tax plan would keep the provisional income calculation or treat all Social Security benefits as taxable ordinary income. If the Trump tax plan eliminated the provisional income calculation, effectively making all Social Security benefits taxable as ordinary income, that same couple would pay roughly $1,775 in federal income tax in 2017.
If the Trump tax plan retained the current provisional income calculation, the same couple could collect their Social Security benefits and withdrawal of $32,000 from their IRA before paying any federal income tax.
These are two dramatically different outcomes and both would leave significant ripple effects in retirement income plans. However, some things won’t change — there will continue to be different treatment for ordinary income and long-term capital gains and qualified dividends. So, understanding and identifying the impact of harvesting from different accounts at different points in retirement should continue to add significant value to client lives. Regardless of the final form of the Trump tax plan, your clients and others in your community will be curious to understand how it impacts them in both the short and the long term. Covisum will certainly be paying attention to how Social Security will be treated under a new tax plans and we'll update you here. Stay informed, so you can be the expert for your clients.
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