Any time major tax changes are put on the table, I get that feeling like a kid on Christmas Day: giddy, excited, even a little wondrous. What will I find when I unwrap the package? What possible new tax strategies will arise? Oh Joy! Whatever your political leanings, if you are interested in taxes, then these are exciting times. Here’s are my thoughts on Trump’s tax plan, and how it would impact Early Retirement.
Update: This post reviews Trump’s original tax proposal released in September 2017. On December 15, the GOP released the final version of the 2017 tax bill which will be signed into law, and there are many differences between the final version and Trump’s original proposal. See my latest post about how the 2017 GOP tax bill impacts the FIRE community, including how to pay zero taxes.
First off, please realize that the political messaging squads are out in full force, on both sides of the aisle. You can’t believe much of what you hear about Trump’s tax plan, without going through the details and understanding how those details impact various tax situations. To form your own opinion about the proposal, you should really understand how it will impact your own situation. Here is the unfiltered original proposal.
Here are the major points of the proposal, focusing on individuals, and specifically the issues that commonly impact the Early Retirement community:
- Double the standard deduction to $12,000 per individual and $24,000 per couple
- Eliminate most itemized deductions, with the exception of the mortgage interest deduction and the charitable donation deduction.
- Eliminate personal exemptions
- Reduce the number of tax brackets to 12%, 25%, and 35%, thus lowering the highest rate, and increasing the lowest rate from 10% to 12%
These changes will impact different people in different ways. For a lot of taxpayers, these specific changes will reduce taxes. That’s because most taxpayers do not have itemized deductions exceeding the new proposed higher standard deduction amounts of $12,000/$24,000 per individual/couple.
Even under existing tax law, only 30% of taxpayers itemize their deductions. Thus, under Trump’s proposal, at least 70% of taxpayers will benefit from a higher standard deduction.
While Trump’s plan proposes to reduce the number of tax brackets, we don’t know yet where the income cutoffs for those brackets will fall. Thus, we don’t know the real impact of the new brackets yet either.
Location, Location, Location
Whether you benefit from these changes will depend a lot on where you live. For folks living in high cost of living states, such as California and New York, the increase of the standard deduction and elimination of most itemized deductions may easily result in a substantial tax increase.
That’s because many more taxpayers in high-cost states itemize their deductions, due to high taxes and high housing costs. Taxpayers in states like California rely heavily on the mortgage interest deduction as well as the deduction for state, local, and real estate taxes. Since the latter will be eliminated under Trump’s tax plan, California taxpayers could be hit hard.
While the mortgage interest deduction would remain intact under Trump’s plan, it will be a moot point for most taxpayers. The average mortgage interest deduction is much smaller than the new proposed higher standard deductions. With the elimination of other big deductions like the deduction for state, local, and real estate taxes, more taxpayers will no longer have enough total deductions to surpass the standard deduction threshold. Thus, few taxpayers will be able to claim the mortgage interest deduction.
If Trump’s plan becomes law, more taxpayers will just take the standard deduction instead of claiming the mortgage interest deduction. Trump’s tax plan effectively eliminates the mortgage interest deduction for most taxpayers, without actually eliminating it.
Impact of Deductions on Early Retirees
How do these changes to deductions impact early retirement dreamers? There are two takeaways: First, don’t live in a state like California! Trump’s tax plan may likely increase your taxes in high cost states like California and New York, but reduce them in lower cost states. If the plan passes into law, there will be even more incentive to move to lower cost states to help your nest egg endure a long and fruitful retirement.
Second takeaway: As the mortgage interest deduction effectively becomes moot for most taxpayers, this increases the incentive for early retirement dreamers to pay off their mortgage early. My personal retirement plan until now has been to keep my mortgage during retirement, so that I can claim the deduction. I may need to rethink my plan if Trump’s proposal becomes law.
Related Content: Just how much can you save by moving to a lower cost of living area? See An Extreme Cost of Living Comparison: Southern California vs. Rural Bolivia
The Zero Tax Bracket
The “Zero Tax Bracket” or “Zero Tax Threshold” is important for early retirees. This determines the amount of money you can make – via part-time work or taxable investments – and still pay no income taxes. Under Trump’s plan, the zero tax bracket will increase for most taxpayer statuses, but it will decrease for some.
The top of the zero tax bracket is calculated as the sum of the standard deduction plus personal exemptions. Personal exemptions would be eliminated under Trump’s plan, but the standard deduction will double. Whether the zero tax bracket increases or decreases for you will depend on how many personal exemptions you claim. Here’s the detail:
Changes To The Zero Tax Bracket – How Much Money You Can Earn And Pay No Taxes
|Taxpayer Status||Current Tax Law, 2017||Trump's Plan|
|Single, Over 65||$11,650||$12,000*|
|Married Filing Jointly, No Kids||$20,800||$24,000|
|Married Filing Jointly, No Kids, Over 65||$23,300||$24,000*|
|Married Filing Jointly, 2 Kids||$28,900||$24,000|
*Trump’s plan is to eliminate personal exemptions. I assume that also means the additional exemption amount for taxpayers over 65 years old – but of course whether that happens will depend on what is passed into law.
The takeaway here is that the zero tax bracket will increase moderately for most taxpayer statuses. That’s a great thing for most regular retirees. If your kids have already left the household, and are no longer your dependents, this will make it easier to retire or to stay retired.
However, if you have a family with dependents (and therefore more personal exemptions), your zero tax bracket may decrease. In the case of a married filing jointly couple with two kids, the zero tax bracket would decrease by over $4,000. And the more kids you have, the worse it will be. For those who want to retire early with kids, Trump’s proposal may decrease your zero tax bracket.
10% Tax Bracket Increases to 12%
Once you surpass the zero tax bracket, under Trump’s plan retirees will pay higher marginal taxes. Under current tax law, the lowest tax bracket is 10%. But, Trump’s proposal would increase the lowest bracket to 12%.
But due to the generally higher zero tax bracket, this may or may not result in higher taxes paid – it depends on your filing status and how much money you make.
The takeaway for early retirees is that it becomes more important to keep your retirement income within the zero tax bracket, if you can. The penalty for surpassing the zero tax bracket is 20% higher under Trump’s plan!
What To Watch For
Trump’s tax plan at this point is merely a proposal, without a ton of detail yet. Details will be hammered out as it goes through Congress, and the final version that becomes law could be quite different. Some of the things early retirement dreamers will want to watch for include:
- What will be the income cutoffs for the new tax brackets? This is a key question that will affect everyone. The new 12% rate may be higher than 10%, but it is still a relatively low tax rate. And we don’t know how high it will go. If the new tax law raises the income levels to which the new 12% rate applies, this could be a significant boon to retirees with incomes from investments or part-time retirement work.
- Will there be any benefits for taxpayers over 65? The proposal is to eliminate personal exemptions – presumably this includes the additional exemption for taxpayers over 65. The impact could be a stronger incentive to retire early – as it will become less attractive to wait.
- What will be the impact on rules for retirement accounts? The proposal says its aim is to retain retirement benefits, but simplify the rules and “improve their efficiency”. How? We don’t know yet. The devil will be in the details.
My Own Personal Impact
In my own case, Trump’s plan may not have a very big impact on my taxes. Our U.S. residence is in California, and our itemized deductions are about equal to the proposed higher standard deduction for married couples ($24,000). Thus, we won’t benefit from the higher standard deduction. But with two kids in tow, the elimination of personal exemptions will undoubtedly raise our taxes (Those Damn Kids!).
However, Trump’s proposal says it will raise the phaseout of the child tax credit, which could offset that tax increase a bit for me. Also, if the new 12% bracket is expanded, my taxes could still decrease. It all depends on where our income falls in the new brackets.
So, at this point, it’s just too early to tell how it will impact me. I suspect it won’t have a huge impact. I’m not quite ready to pack my bags to flee California. But I’ll be eagerly watching the deliberations in Washington!
Update: This post reviews Trump’s original tax proposal released in September 2017. A revised GOP tax plan was released on November 2, 2017. See my more recent post about the latest GOP tax plan, the zero tax brackets, and early retirement here.