Happy Monday, folks! Last week, the Senate released it’s version of tax reform. If you want to read about all the differences from the previously released House tax plan, you can go here. There are a couple of items in the Senate tax plan that I want to highlight, which I think will be of particular importance to the early retirement / FIRE community.
Here is the original version of the 2017 Senate tax plan, straight from the horse’s mouth.
I want to highlight three important points about the Senate tax plan, which will be of particular interest to the early retirement / FIRE community.
- Under the Senate tax plan, there will be better reason to pay off your mortgage early and avoid living in a high cost state.
- The Senate tax plan leaves retirement accounts largely untouched – along with related tax strategies.
- Small businesses, side hustles, and even temporary contract work are going to become even more marvelous.
1. The Mortgage Interest Deduction Is Moot
Both the House and the Senate tax plans nearly double the standard deduction to $12,000 individual / $24,000 couple. This is going to make more people rely on the standard deduction, rather than itemizing. Already, 70% of taxpayers use the standard deduction, but increasing it to $12,000 / $24,000 is going to make around 90% of taxpayers use it.
As the standard deduction is increasing, certain deductions are being eliminated. The Senate tax plan keeps the popular mortgage interest deduction largely intact, but it eliminates the state and local tax (SALT) deduction, including for property taxes. These two popular deductions are overwhelmingly used by higher income taxpayers in higher income states – like California and New York.
But, most taxpayers would need BOTH the mortgage interest deduction AND the SALT deduction in order to surpass the new higher standard deductions. So, by eliminating the SALT deduction, very few taxpayers will have enough mortgage interest to still itemize. In other words, the Senate tax plan effectively makes the mortgage interest deduction moot.
Just to give you an idea, at current mortgage rates, if you buy a $1M house, you’ll need about a $800,000 mortgage. That mortgage, if it were 30-year fixed would only generate more than $24,000 of interest expense for the first five years or so. After that, a married couple would be on the standard deduction for the remainder of the mortgage, unless they have other large deductions.
What’s more, equity loans would no longer be eligible for deduction under the Senate tax plan. Since many folks buying $1M homes get one conforming mortgage and a second equity loan, this means even fewer people would be able to deduct. And finally, the mortgage interest deduction is already limited to mortgages under $1,000,000. So, we’re talking about a very narrow strip of homeowners that would continue using the mortgage interest deduction.
Pay Off Your Mortgage Early
The most immediate impact for early retirement dreamers is that it becomes more attractive to pay off your mortgage early. If you can’t access the tax benefit, then mortgage debt becomes effectively more expensive. I have only been paying the minimum on my mortgage because the rate is so low and the tax deductions are so beautiful. But there are good reasons to pay off your mortgage early, for example, massive college discounts for your kids. I may need to reconsider if the Senate has its way.
Don’t Live In A High Cost State
But besides that, the Senate tax plan is going to make it even less attractive to live in a high cost of living state. Eliminating the SALT deduction and making the mortgage interest deduction inaccessible effectively raises taxes in high cost states like California and New York, where taxpayers today heavily rely on those deductions.
If your FIRE plan is to move to a lower cost of living area once you achieve your financial independence, then the Senate tax plan makes that move all the more urgent. My personal plan is to stay in California, and work a few more years to pay for it. But, under the Senate tax plan, I may want to reconsider, as it will become even more expensive to live in there.
2. Retirement Accounts Unscathed
***Update: Just hours after I posted this, the Senate released an amendment which would change catch-up contributions for everyone over 50. The maximum catch-up contribution would increase from $6,000 to $9,000 (yay!), but they would only be available for after-tax Roth accounts, not normal pre-tax 401(k)s (boo!). This is a pretty significant change. You can read more about it here. We’ll see what happens in the final bill.*****
The Senate tax plan only proposes minor changes to retirement account rules. The popular tax strategies the FIRE community has come to rely on to minimize taxes and build wealth are not impacted. The most significant change in the Senate tax plan to retirement accounts is that people who earn more than $500,000 in wages cannot make catch up contributions to defined contribution plans like the 401(k). This will basically impact about zero people who really care about it. Because if you have more than $500,000 in wages, then you’re probably not structuring your income correctly!
As a refresher, current catch up rules for the 401(k) allow people over 50 years old to contribute an additional $6,000 per year. This means someone over 50 can contribute a total of $24,000 to a 401(k)… (unless, of course, they have a solo 401(k), in which case they can contribute up to $54,000… but I digress)
Those catch up contributions are really the only reason that I sometimes wish I were over 50.
I’m relieved to see that the Senate tax plan isn’t gutting retirement accounts. In fact, neither the Senate nor the House versions of tax reform are making any major changes to retirement at this point. That’s good because retirement accounts are the primary tool that working stiffs can use to become financially independent. Any reduction to the amount of money we can squirrel away into tax protected accounts like the 401(k) is a hot poker in the eye of the FIRE dream.
Although, we’re not out of the woods yet. There has been a lot of talk about making more substantial changes to retirement accounts, and not in a good way. I’ll be watching closely until there is a final bill passed.
3. Get Your Side Hustle On!
The last point I wanted to make about the 2017 Senate tax plan is that small businesses and side hustles are going to get a whole lot more marvelous. Side hustles are an important tool to boost your financial freedom. See Ten Reasons You Need A Side Hustle.
Here’s what’s happening under the Senate plan: most small businesses will be able to deduct 17.4% of their business income, subject to a few limitations. The deduction will be available for pass-through businesses, such as partnerships, s-corporations, as well as sole proprietorships.
So, for example, if you make $20,000 from your business, then you can deduct 17.4% of it, or $3,480. This is like getting a 17.4% tax discount off your small business income. With this proposal, there will be yet another good reason to have a side business.
The 17.4% deduction is subject to some limitations. The biggest limitation is that it is not available if you have a service businesses and make more than $150,000 married / $75,000 individual. Specifically, such service businesses include lawyers, accountants, brokers, performing artists, or any service provider “where the principal asset of such trade or business is the reputation or skill of one or more of its employees.”
A Benefit For Contractors And Freelancers
Even freelancers and independent contractors would be eligible for the same 17.4% deduction. Corporations often hire temp workers or independent contractors because it is cheaper than having full-time employees – often to the detriment of the employee. But this proposal would make contracting a bit more attractive. It’s like getting a raise just for changing your employment status. (Of course, this will not offset other costs of being a contractor, such as fewer benefits and self-employment taxes… but this would make contracting better than it currently is.)
I’d personally love to see this deduction happen. My wife has a small home business, and I also plan to seek temp/contract work in the future. Contract work offers greater flexibility for a free lifestyle than regular employment. I will continue working at least part time because early retirement is dead to me.
There are many other differences between the Senate tax plan and the House plan. These are only three points that I wanted to highlight, which I think are more important to the early retirement / FIRE community. There are also many similarities between the two plans, which will probably make their way into the final bill: the increase in the standard deduction, the elimination of personal exemptions, and the elimination of many itemized deductions.
At this point, everything is just a proposal. But things seem to be moving quickly, and we may have a final bill in the coming weeks. That’s when it will get real interesting.