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How the 2017 Tax Bill Impacts Early Retirees

Current laws bestow many lucrative tax breaks upon early retirees.

But does the 2017 Tax Bill undercut any of these helpful rules?

To explore this issue—a “burning” one for FIRE fanatics—here’s a rundown of ten favorable tax provisions I’ve followed for years (see my 2015 article here and my 2016 article here).

As you’ll see, some provisions have changed for the better and others for the worse. On balance, the new law continues to help early retirees.

The details appear below . . . .

1. Low Federal Tax Rates for Early Retirees
New Law Is Better: 15% & 25% Brackets Lowered to 12% & 22%

When full-time work ceases, taxable income plummets. Accordingly, most early retirees qualify for lower tax brackets.

Under the old law, the lowest brackets were set at 10, 15 and 25 percent. The 2017 Tax Bill revises those brackets to 10, 12 and 22 percent. But the lower rates won’t last forever. The brackets return to their previous levels after 2025.

Here’s a comparison of the old versus new tax rates for individuals and married couples who file joint returns:

SINGLE TAXPAYERS    
2018 Income Old Law Rate New Law Rate
$0 – $9,525 10% 10%
$9,526 – $38,700 15% 12%
$38,701 – $93,700 25% 22%
MFJ TAXPAYERS    
2018 Income Old Law Rate New Law Rate
$0 – $19,050 10% 10%
$19,051 – $77,400 15% 12%
$77,401 – $156,150 25% 22%

At the relatively modest income levels of most early retirees, the new rates will produce slightly lower taxes. For example, a single filer who reports $50,000 in taxable income will pay $1,214 less, which reflects a tax cut of 2.4 percent. A married couple who files jointly and reports $100,000 in taxable income will pay $2,428 less, which also reflects a 2.4 percent cut.

2. Tax-Free Capital Gains
New Law Is the Same: No Change

See no. 3 below.

3. Tax-Free Qualified Dividends
New Law Is the Same: No Change

Under the old law, filers in the 10 and 15 percent tax brackets paid no taxes on capital gains or qualified dividends. See IRS Publication 550. The new law extends these same breaks to those in the 10 and 12 percent tax brackets.

4. Obamacare Premium Tax Credits
New Law Is Worse: No Changes to Tax Credits, but Premiums Will Rise

In 2017, Obamacare survived repeal by the slim margin of a single vote in the US Senate. As a result, in 2018 early retirees can still qualify to receive a Premium Tax Credit (PTC). For details, see IRS Publication 974.

Although the 2017 Tax Bill didn’t repeal Obamacare itself, it did eliminate the penalty for not buying insurance. The repeal takes effect in 2019. Experts predict this change will increase premiums for Obamacare recipients. Why? Because the young and healthy will skip buying insurance, which in turn will increase premiums for the old and sick. Effectively, these higher premiums impose an indirect tax upon anyone who continues to use Obamacare.

5. Roth Conversions
New Law Is the Same: But Increases Incentives to Convert 

Subject to various rules, the IRS permits filers to transfer money from traditional IRAs into Roth IRAs, a process known as a “Roth Conversion.” See IRS Publication 590-A.

The 2017 Tax Bill increases incentives for early retirees to make Roth Conversions. Here’s how.

Conditions under the old law already encouraged Roth Conversions. Retirees in their thirties and forties could reasonably predict that their tax rates would rise by the time they reached their sixties and seventies. After all, rates were low and $20 trillion in federal debt foreshadowed higher taxes. In that climate, immediate conversions to Roth accounts at the prevailing rates looked profitable—future withdrawals from traditional IRAs would almost certainly involve higher taxes.

The new law boosts the existing incentives to convert in several ways. First, it increases the already massive federal debt by $1.5 Trillion. Second, it further slashes historically low tax rates. Finally, it announces that tax rates will rise again after 2025—thus sending a clear message that the time for Roth Conversions is during the next eight years while lower rates prevail.*

6. HSA Contributions
New Law Is the Same: No Change

Early retirees with qualifying health insurance will continue to enjoy the benefits of Health Savings Accounts (HSAs). See IRS Publication 969.

7. Itemized Deduction of Medical Expenses
New Law Is Slightly Better: But Few Early Retirees Will Benefit 

Under prior law, medical expenses were deductible only to the extent: (1) the filer itemized; and (2) the expenses exceeded 10 percent of adjusted gross income (AGI). The AGIs of full-time workers were usually too high to deduct medical expenses. But early retirees earn less and therefore found it easier to exceed the AGI threshold.

The 2017 Tax Bill lowers the AGI threshold for deducting medical expenses from 10 percent to 7.5 percent, but only for tax years 2017-2018.

At first blush, the new law appears to liberalize the medical expense deduction—at least for two years. At the same time, however, the new law almost doubles the amount of the standard deduction through tax year 2025. For single filers, the standard deduction jumps to $12,000 (up from $6,350). For MFJ filers it jumps to $24,000 (up from $12,700).

Such lofty standard deductions will deplete the ranks of itemizers. Under the old law, about 30 percent of filers itemized. Under the new law, only about 10 percent will do so. With hardly any itemizers, few FIRE fanatics will be deducting their medical expenses.

8. Itemized Deduction of Sales Taxes
New Law Is Worse: $10,000 Cap on Deducting State and Local Taxes

Upon relinquishing full-time jobs, early retirees usually pay lower state and local taxes (known as SALT). If they itemize, this reduces their available deductions. But there’s good news: they can make up for this loss by electing to deduct their sales taxes in lieu of their income taxes. See 2017 Form 1040, Schedule A, line 5b.

Under the old law, almost all early retirees could deduct SALT, including sales taxes, without limitation (at the highest incomes deductions were phased out, but retirees rarely earn that much).

The new law makes it far more difficult to deduct sales taxes. First, Congress has almost doubled the standard deduction, a change that will severely limit the ranks of itemizers (see no. 7 above). Second, Congress has capped all SALT deductions, including sales taxes, at $10,000 per year through 2025. Finally, the $10,000 cap isn’t indexed for future inflation. So with each passing year, it will affect more early retirees.

9. Moving to States with Lower Taxes
New Law Is the Same: But Increases Incentives to Relocate

Without the burden of full-time jobs, early retirees have more choices about where to live. Many of them seize this opportunity by moving to states that offer lower taxes and/or living costs.

By boosting the standard deduction and capping SALT at $10,000, see nos. 7-8 above, the new law increases the incentive for those who live in high-tax states to move away. For example, itemizers with SALT of $32,000 who are in the 22 percent bracket will owe $4,840 more in taxes each year (($32,000-$10,000) * 22% = $4,840). This certainly makes Cheyenne winters look more bearable (Wyoming charges no income tax and neither do a handful of warmer states such as Florida and Nevada).

10. Tax-Free Home Sales
New Law Is the Same: No Change

Without a job tying them down to a particular address, early retirees find it easier to sell their homes (often downsizing in the process). If they’ve lived in their house for two of the last five years, they can sell without incurring taxes on their profits—up to $500,000 for married couples and up to $250,000 for singles. For details, see IRS Publication 523. The new law leaves these beneficial provisions untouched.

*   *   *

Overall, the new law inflicts little harm upon early retirees.

Unchanged Provisions

Early retirees will still qualify for tax-free capital gains and qualified dividends at the same income levels as under the old law. They will still be allowed to make Roth Conversions (in fact, the new law increases their incentives for doing so). They will still be permitted to cut taxes by contributing to HSAs. And they will still enjoy tax-free profits on qualifying home sales.

Better Provisions 

Many early retirees will qualify for lower tax brackets (15 percent drops to 12 percent; 25 percent drops to 22 percent), but these expire after 2025.

During the 2017-2018 tax years, the few early retirees who itemize will benefit from a lower AGI threshold for deducting medical expenses: 7.5 percent instead of 10 percent.

Worse Provisions 

Those who stay in Obamacare will see their premiums rise as healthy people leave the system once the insurance mandate penalty disappears in 2019.

The $10,000 cap on SALT deductions will impact many early retirees who live in high-tax jurisdictions. These taxpayers will now hear the same advice from their CPAs that they’ve heard from their doctors: “enjoy early retirement, but be sure to keep your SALT levels low!” 🙂 🙂 🙂

*Although the new law makes no changes to Roth Conversions, it does repeal rules which had permitted “Roth Recharacterizations.” Under these rules, filers who made a Roth Conversion in the immediate prior tax year were allowed to reverse their conversion—i.e., to return some or all of the converted funds back to their traditional IRAs. The new law prohibits such do-overs.

Photo Credit—White House Public Domain

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6 Responses to How the 2017 Tax Bill Impacts Early Retirees

  1. Kimberly December 27, 2017 at 7:03 AM #

    Great post! Thanks for breaking it down!

    • A Noonan Moose December 27, 2017 at 8:58 AM #

      Thank you very much Kimberly!

  2. Bonnie Bossert Belza December 27, 2017 at 7:00 PM #

    Is the recharacterization change effective for 2017 Roth conversions or only 2018 and beyond?

  3. A Noonan Moose December 28, 2017 at 9:09 AM #

    Bonnie B. has asked: “Is the recharacterization change effective for 2017 Roth Conversions or only for 2018 and beyond?”

    My response follows:

    This is an absolutely excellent question that i was worried someone might ask. So congratulations for putting me on the spot! 🙂

    I’ve read the statute and to my reading its language is ambiguous on the issue you raise.

    Although there are some interpretive maxims that might cause a tax judge to resolve this ambiguity in favor of the taxpayer and against the government, to be on the safe side anyone who already knows they want to recharacterize a 2017 Roth Conversion would be well advised to do so by December 31, 2017. This is the conservative view expressed by PBS retirement guru Ed Slott, who writes:

    “The new law repeals the Roth recharacterization after 2017, which effectively means that any 2017 Roth recharacterizations must be completed by the end of this year, or your clients will be stuck with the tax bill.

    Some of those following this legislation have commented that this repeal may only be for 2018 Roth conversions, so in that case you would still have until October 15, 2018 to undo a 2017 Roth conversion. I don’t see it that way and wouldn’t risk taking that position with a client. The provision states that recharacterizations are repealed after this year, meaning that the recharacterization option no longer exists in 2018. Even if this is not perfectly clear yet, I still would not take a chance. Advisors should protect clients and assume that recharacterizations of 2017 Roth conversions will no longer be available after year-end.”

    To read Mr. Slott’s article in its entirety, click here.

    Thanks for asking such a great question!

  4. Bonnie Belza December 28, 2017 at 2:34 PM #

    Thanks for the link! I’ve got today and tomorrow to change my mind on what I converted this year!

    • A Noonan Moose December 28, 2017 at 2:57 PM #

      You’re welcome–good luck with your tax planning!

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