As Trump’s administration crafts its tax reform agenda, Americans will have to evaluate how his plan will affect their immediate and long-term investment goals.
While there is still much to be decided, we take a look at five ways in which Trump’s proposed tax plan could affect your investments.
Repeal of the 3.8% tax on investment income
The tax on investment income for high earning individuals, trusts and estates — sometimes referred to as the ‘3.8% Medicare Surtax’ — is under increased scrutiny by the Trump administration.
The tax, enacted as part of the Health Care and Education Reconciliation Act of 2010, went into effect in 2013. Distributions from qualified retirement plans are exempt but distributions of investment income from other accounts are not exempt.
A repeal of this tax would spell good news for investors, potentially translating into higher levels of income and greater returns if savings are reinvested. Any repeal could also encourage people to invest in income-generating options such as bonds which are generally considered safer investments.
While the potential repeal of this tax is a welcome development for high earning investors, any plans to recoup the lost revenue will likely center on taxpayers.
Pre-tax contributions to 401(k)s at risk
It is uncertain whether the Trump administration will look to end current 401(k) rules regarding tax deductions. Concerns about the impact of Trump’s proposed tax breaks on the budget deficit have led to suggestions that his administration and Congress could try to eliminate the pretax status of 401(k) contributions in favor of a Roth-IRA style tax status if other revenue-generating options are exhausted. Currently, 401(k) plans are funded with pretax dollars and assets are only taxed upon withdrawal — meaning tax revenue is deferred.
Confusion grew when White House Press Secretary Sean Spicer stated that Trump’s proposed tax treatment of 401ks would only protect charitable giving and mortgage deductions. The White House later clarified the administration’s stance to say there was no plan to change the rules for taxing 401(k) contributions.
But any attempt by Congress to implement a change to the tax status of 401(k) contributions could have serious consequences for future retirees. Many see the pre-tax status of 401(k) plans as an essential incentive for younger individuals to save for retirement. Removing such an incentive could deter people from saving for retirement through a 401k plan.
Repeal of the estate tax
The estate tax, which in 2017 will see estates valued at more than $5.49 million subject to a 40% tax, is also under review. Those in favor of eliminating the estate tax argue that it accounts for less than 1% of tax revenue. Approximately the largest 0.2% of estates pay the tax, translating into a few thousand wealthy American households.
Any elimination of the tax would result in an overhaul of traditional estate planning. High-net-worth investors will need to speak to their financial advisors about how a rule change could affect them and their beneficiaries.
Beneficiaries, primarily the children and grandchildren of wealthy estate owners, will profit most from a rule change. The majority of Americans would not be directly affected.
Lower income tax brackets
Trump’s plan calls for reducing the number of tax brackets from seven (10%, 15%, 25%, 28% 33%, 35% and 39.6%) to just three: 10%, 25% and 35%. Those currently in the 39.6% bracket would immediately drop to the 35% group and some in the in-between brackets (15% and 28% bracket) would also drop to lower categories.
These individuals may benefit from contributing to an after-tax retirement account such as a Roth IRA rather than a pre-taxed account. This will allow them to take advantage of lower tax rates now rather than waiting to pay taxes when they make withdrawals from their retirement accounts.
Reduction of business taxes
The US has one of the highest corporate tax rates at 35%. The Trump administration has proposed lowering the rate to 15% — a big win for many businesses.
Personal business income is currently taxed at the individual rate, but under Trump’s proposal it would be taxed at the corporate rate (15%). Some Individuals owning a proprietary business could therefore find themselves in a lower tax bracket. As with those in a lower income tax bracket, this will present individuals with the opportunity to save for retirement at a lower tax rate now rather than a potentially higher rate in the future.
Furthermore, investors could receive larger dividend payments if corporations repatriate foreign cash as a result of lower taxes. Lower tax rates could encourage corporations to return profits to the US which would ultimately benefit shareholders.
Ultimately, changes to the federal tax code will impact the investment and retirement landscape and investors should speak to their advisors about drawing up appropriate action plans.