A Hall of Fame baseball player once observed, “When you come to a fork in the road, take it.” The same can be said about the impact of this year’s tax reform on retirement savings.
When tax reform was enacted earlier this year, many people lauded the reduction to personal income-tax rates as a bonanza for retirement savings. Common wisdom held that lower rates made it more appealing to contribute after-tax dollars to a Roth 401(k) or Roth IRA rather than save on a pre-tax basis in a conventional 401(k) or IRA.
The prescription seemed straightforward, especially given that tax rates are due to return to their pre-tax reform levels in 2025. But tax issues are rarely, if ever, simple. In reality, decisions about pre- and post-tax salary deferrals continue to be different for each taxpayer.
The reason is found in the mechanics of how taxpayers calculate their federal income tax bill. The total is not based just on tax rates but rather a combination of tax rates and taxable income. While it’s inarguable that personal income tax rates have been cut for many taxpayers, whether the resulting tax liability increases, decreases or stays the same depends on whether the reduction in tax rates can offset the increase, if any, in taxable income.
One commonly discussed factor is the limit on federal income tax deduction for state and local taxes, the so-called “SALT deduction.” Prior to tax reform, a taxpayer could deduct all state and local taxes, which included income and property taxes (and possibly others), when calculating his or her taxable income on the federal income tax return. Tax reform capped this deduction at $10,000. As a result, taxpayers in locations with moderate to high income-tax and property-tax rates may now see their overall taxable income, and with it their taxes, increase.
Small-business owners face additional complexity. An owner of a business that operates as a “pass through entity” such as a sole proprietorship, partnership, or “S Corporation” pays taxes on his or her share of business profit at his or her individual income-tax rate. Tax reform created a “pass through exemption” that may allow the business owner to deduct up to 20 percent of qualified business income when calculating his or her individual taxable income. Complex rules applied to this deduction may limit or eliminate the deduction under certain circumstances.
Factors with broader applicability are at work, too. Tax reform eliminated the personal exemption previously employed by many taxpayers and increased the standard deduction. These factors may combine to increase or decrease taxable income.
As an example, consider a family of two adults and two dependent children using a tax filing status of “married filing jointly” and not itemizing exemptions. Prior to tax reform, this family would have enjoyed four personal exemptions at $4,050 each for a total of $16,200. At the same time, the standard deduction would have been $13,000. After Tax Reform, their personal exemption total of $16,200 is eliminated while the standard exemption increases by $11,000. The net result is an increase in taxable income of $5,200.
In this situation, it may be beneficial for the taxpayers to contribute to their 401(k) or other employer-sponsored retirement savings plan on a pre-tax basis, if they are not doing so already, or are not contributing the maximum amount allowed. The federal contribution limits for defined contribution plans are rising by $500 in 2019 to $19,000. For those age 50 and older, the catch-up contribution remains at $6,000 for a total of $25,000 in pre-tax contributions.
In a similar example, let’s assume that the two children were ineligible to be treated as dependents for tax purposes, which reduced the total of personal exemptions to $8,100. However, the $11,000 increase in the standard deduction would still apply, netting a reduction in taxable income of $2,900. In this instance, the couple might consider earmarking at least some retirement savings to a Roth 401(k) on an after-tax basis, which could potentially yield tax-free income at retirement.