It might not be very good for Illinois homeowners - and much may still change about the tax reform proposal that came out of the house last week - but it’s worth discussing the implications of what’s currently on the table. One of the most important things to remember when it comes to getting to paying no taxes in retirement, you have to be willing to pay some tax. Given this impending tax legislation, some people have been putting their planning on hold until they have a little more certainty surrounding the actual amount of tax they’ll have to pay. So, all this begs the question, does this tax reform proposal truly decrease the cost of getting to the 0% tax bracket or paying less tax in retirement?
I can give you a very straightforward answer. It depends. First, let’s identify the primary changes to the tax code that will affect you. In the current proposal, the number of tax brackets gets reduced from 7 to 4 (5 if you make more than $1M). See the table below on the differences:
In the current proposal, a portion of the 15% bracket gets absorbed into the 25% bracket (good) and the 25% bracket gets extended all the way to $260,000 (even better!), formerly the realm of the 28% and 33% brackets. So, on the surface, it looks like there’s no question that taxes will be saved. In fact, I did an actual calculation of tax savings were a party to realize enough taxable income to reach the top of the 25% ($260,000 of taxable income). According to my calculations, their effective tax rate would be 20.5%. Contrast that with an effective tax rate of 23.46% under the old tax rates. That’s a savings of $7,714! The cost of getting to the 0% tax bracket may have just gotten cheaper!
Worthy of note, however, is that this tax reform proposal does eliminate and simplify many deductions. In some cases, this serves to offset some of the tax savings mentioned above. For example, the proposal calls for the elimination of the deduction for state taxes. So, were you to normally pay 5% state tax on $260,000, that’s a $13,000 deduction that just went up in smoke. At 25% tax, that lost deduction will cost you an extra $3,250. That brings our total tax savings on the first $260,000 of income down to only $4,464.
In conclusion, should this proposal go through in its current form, it will be easier and more cost effective for you to get to the 0% tax bracket, if only marginally in some cases. More importantly, this bill would create more certainty in the planning process so that you can make asset-shifting decisions with confidence. Further, because this proposal would get approved under budget reconciliation, it would expire in 10 years. That means that will experience historically low tax rates for 10 years and know the year and the day when those taxes will go back up again. Talk about a window of opportunity! Should this legislation go through, it will create a period of historic opportunity to adopt the zero tax paradigm!
That's just the way it works!