What’s the potential impact of tax reform on individuals?
In the days following the release of the proposed Republican “framework” for implementing tax reform, issues have been raised about its contents. For example, some analysts and organizations have argued that large tax cuts would significantly increase the deficit if the economic growth projected by Republicans fails to materialize.
President Trump has said his plan, released in a nine-page document titled “Unified Framework for Fixing Our Broken Tax Code,” is aimed at cutting taxes and creating jobs. It also strives to make the Internal Revenue Code simpler. Let’s take a closer look at how the proposal may affect individual taxpayers.
Individual tax rates
The framework would reduce the number of individual tax rates from the current seven to three: 12%, 25% and 35%. Under current law, the highest rate is 39.6%. The framework reserves the right to add a fourth rate that would be higher than 35%. That might prove necessary to answer critics who argue the plan is a “giveaway to the rich.”
The framework doesn’t specify the income levels that will determine the new tax brackets. However, during the presidential campaign and shortly thereafter, President Trump proposed the following brackets:
For single filers:
- Less than $37,500: 12% tax bracket
- $37,500 to $112,500: 25% tax bracket
- More than $112,500: 35% tax bracket
For married couples filing jointly:
- Less than $75,000: 12% tax bracket
- $75,000 to $225,000: 25% tax bracket
- More than $225,000: 35% tax bracket
These brackets would eliminate the “marriage penalty” on many double-income households, because all of the joint filer brackets would be twice those of single filers. And it could enhance the “marriage bonus” for some married couples where one spouse is a stay-at-home parent or one spouse makes substantially more than the other spouse.
However, some filers, both married and single, could find themselves facing a tax increase, in some cases a substantial one. For example, if the previously proposed brackets come to fruition, some taxpayers currently in the 28% bracket and generally all taxpayers in the 33% bracket would be pushed into the 35% bracket (though a portion of their income would be subject to lower rates than they’re currently paying).
The original Trump tax plan also proposed eliminating the head-of-household filing status, which is commonly used by single parents with dependent children because it’s more beneficial than single-filing status. The new framework is silent on the fate of the head-of-household filing status, but doing away with it could result in higher taxes for single parents and, therefore, prove to be controversial.
Whatever the tax rate brackets turn out to be, they’ll likely be adjusted annually for inflation, as under current law. However, the framework states that it would use a “more accurate” measure of inflation to do so.
Changes to current tax breaks for individuals
Several existing tax breaks would change substantially under the framework, and in many cases be reduced or eliminated. Crafters of the framework say that the changes would simplify tax filing and that, when combined with the changes to the tax rates, would still result in reduced taxes for middle- and lower-income families.
Because the framework doesn’t include a lot of specifics and there are many variables involved, the extent to which middle- and lower-income taxpayers would see a tax reduction is currently unclear. Here are the key breaks that would be affected:
Personal and dependent exemptions and standard deductions. Under current law, personal and dependent exemption deductions are $4,050 each for 2017. The standard deduction is $6,350 for single taxpayers and married individuals who file separately, $9,350 for heads of households, and $12,700 for married couples filing jointly.
The framework would eliminate personal and dependent exemptions. The standard deduction, however, would be increased to $12,000 for singles and married individuals who file separately and to $24,000 for married couples filing jointly. Again, head-of-household status isn’t mentioned in the framework.
For some taxpayers, the increased standard deduction could compensate for the elimination of the exemptions, and perhaps even provide a small amount of additional tax savings.
But for those with many dependents or who itemize deductions, these changes might result in a higher tax bill — depending in part on what happens with itemized deductions and the child tax credit (see below).
Itemized deductions. The framework would eliminate most itemized deductions but retain the write-offs for home mortgage interest and charitable contributions.
Advocates for taxpayers in high-tax states are already criticizing the plan’s apparent elimination of itemized deductions for state and local taxes. It could be particularly harmful to homeowners in high-tax states who’ve paid off their mortgages and therefore won’t be able to benefit from the mortgage interest deduction but have large state and local property tax bills, such as many retirees.
But advocates for taxpayers in low-tax states argue that the deduction for state and local taxes is essentially a federal subsidy for those taxes. They say that taxpayers there shouldn’t have to pay more federal taxes just because their state and local taxes are lower.
Eliminating itemized deductions for medical expenses and personal casualty losses could also prove to be controversial because they currently benefit people with high medical expenses and those who have suffered from disasters.
Child tax credit. Without being specific, the framework promises a “significant increase” in the child tax credit, which is currently set at $1,000 per qualifying child. In addition, the income levels at which the credit begins to be phased out would be increased to make the credit available to more taxpayers.
However, until the exact amounts are known, it’s hard to determine if parents will be better off under the proposed plan. Some large families with several children may be worse off because of the loss of the dependent exemption deduction.
It’s also important to keep in mind that the child tax credit currently applies only to children under age 17 at the end of the tax year. Many parents claim dependency exemptions for children into their early 20s, because the children are students and the parents are still financially supporting them. Taxpayers also may currently claim dependency exemptions for elderly parents and others they’re supporting, provided the applicable requirements are met.
Estate tax and generation skipping transfer (GST) tax
Under current law, the 40% federal estate tax affects estates that exceed the inflation-adjusted $5.49 million gift and estate tax exemption. (For a married couple, this means that, with proper planning, generally $10.98 million can be shielded from these taxes.) The 40% GST tax affects gifts or bequests made to beneficiaries who are more than one generation below the giver (such as grandchildren) and that exceed the GST tax exemption (also $5.49 million for 2017). The GST tax is on top of any gift or estate tax due.
The framework would repeal both estate and GST taxes. However, it’s unclear whether the current step-up in basis rule would also be repealed, or perhaps be made subject to a limit. This rule currently allows the basis of an asset to be stepped up to its fair market value on the owner’s date of death. This means that the heir can immediately sell the asset without owing any federal capital gains tax on the sale. Even if the asset isn’t sold immediately, the capital gains tax bill when it is sold generally will be lower with the step-up in basis rule.
For families with estates large enough that they’d be subject to estate tax under the current system, paying capital gains tax rather than estate tax would save tax because of the significant difference between the maximum rates (currently 23.8% vs. 40%). But for families where estate tax currently isn’t a concern, an elimination of the step-up in basis could result in substantially more tax liability for heirs.
Another unanswered question is whether the current gift tax will be repealed, because the framework proposal doesn’t specifically mention it. It is generally believed the gift tax will not be repealed because it provides integrity to the income tax system. Transferring property without boundaries could allow for income from those assets to be shifted to lower tax brackets.
Alternative minimum tax (AMT)
The AMT was originally intended to ensure that high-income taxpayers who claim a large number of write-offs and other tax breaks pay at least some federal income tax. Over the years, however, the tax has morphed into something that hits many upper-middle-income taxpayers — primarily those who have many personal exemptions and who pay high state and local income taxes.
The framework would repeal the AMT. This could save taxes for many upper-middle-income and higher-income taxpayers and simplify tax planning and tax filing for even more taxpayers.
The Republican tax reform framework would make big changes to tax law provisions affecting individuals, but specifics are lacking. Also, there’s always resistance to change.
The House Ways and Means Committee and the Senate Finance Committee will be tasked with the job of filling in the blanks the framework leaves out. The devil will most certainly be in the details. For example, one Republican senator has already stated that he will not support any tax reform package that increases the federal deficit.
The moral: Any road to tax reform will be a bumpy one. We’ll keep you informed of any tax reform developments.
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