Planning your retirement income as a member of FRS is a very intricate process. Depending on your age, your years of service, your job, your FRS choices, and your deferred compensation account, the composition of your retirement income and your taxes will be different. We typically spend several hours with FRS retirees properly planning their retirement income. We encourage you to contact us to schedule your complementary, no obligation conversation about planning your retirement income.
We want to warn you about three examples of FRS retirees receiving bad advice that limited their retirement options.
First, do not rollover your deferred compensation account to an IRA if you are under age 59½. Once this money is placed in an IRA, you have to pay an extra 10% tax penalty to use the money if you are under age 59½. If the funds are left alone in the deferred compensation plan, you have completely flexible access to the funds with no tax penalty. Bottom line, if you are under age 59½, leave your deferred compensation alone.
Second, the guarantees and promises that come with these “new” income approaches that use annuities are simply not as they are described. These guaranteed income streams and returns are filled with caveats, fine print and high costs. These promises don’t actually guarantee any real return on your money as they only apply to internal insurance company values. If FDIC guaranteed CDs are paying around 2% currently, insurance companies aren’t really paying you 5% or more. Bottom line, if it sounds too good to be true, it is.
In addition, the State of Florida is now promoting the use of annuities in its Investment Plan correspondence to state employees. The state’s suggested annuity approach offers an irrevocable option that leaves nothing to your beneficiaries. If state employees prefer a guarantee, they should consider staying with the Pension Plan.
Third, if you are over age 55 and under age 59½ when you retire, you need to leave the amount of money you will need to spend before age 59½ in the FRS Investment Plan. The FRS Investment Plan provides you an exception to draw money out in any amount or frequency without having to incur a 10% tax penalty for early withdrawal if you retire in the year you turn age 55. This is a very valuable option for those that qualify. If all the money is rolled out of the FRS Investment Plan and into an IRA, you lose the flexibility of this option. Bottom line, if you are retiring in the year you turn age 55, you have more flexibility by actually leaving some money behind in the FRS Investment Plan.
Properly planning your retirement income is of the utmost importance. These are just some of the examples we have seen where if the retiree had followed the advice given, they would have effectively eliminated their flexibility in retirement or even worse been subject to an extra 10% tax penalty. Simply rolling over your FRS Investment Plan, DROP or Deferred Compensation account to an IRA may not be the best course of action and could generate an extra 10% tax cost in retirement.
A deferred compensation plan is a type of retirement savings vehicle that is available for government employees. These plans are also known as 457 plans because that is the section of the IRS code that establishes them. All contributions to these plans are done at the discretion of the employee through payroll deferrals. Employee deferrals are the sole source of funding for these accounts. Pre-tax contributions will grow on a tax deferred basis similar to a 401k and are subject to the same maximum contribution limit of $19,000 (plus $6,000 if the employee is over age 50) for 2019. Roth contributions effective January 1, 2011 are also allowed to 457 plans. In addition, once retired, 457 plans can also be rolled into other types of retirement plans such as IRAs but that is where most mistakes happen with deferred compensation plans.
Deferred compensation plans have different features from traditional retirement accounts like IRA’s or 401K’s. The most significant difference is that deferred compensation plans have no 10% penalty for early withdrawal regardless of age. Consequently, you can take distributions from a deferred compensation account and simply pay only the applicable taxes. This is a major advantage and incentive for employees to put some of their paycheck into such accounts over their working years. Having a deferred compensation account gives one a resource to use in retirement without having to worry about an extra 10% tax penalty. In addition, access to the monies in your deferred compensation account is usually available within less than a month after your final day of work. This feature particularly helps retirees under the FRS Investment Plan who have timing issues in accessing their monies.
One of the biggest mistakes retirees can make is to roll their deferred compensation account over to an IRA. Once that money is in an IRA, then the rules of an IRA, particularly those that impose a 10% tax penalty, apply. FRS members should only roll their deferred compensation accounts over once they have passed age 59 ½ when there is no risk of any penalty regardless of the type of account their money is in.
In 2011 with the inauguration of Rick Scott and a Republican Legislature, the Florida Retirement System started to change. These changes were predicated on the aftermath of 2008 on the state’s finances. The market decline during 2008 and 2009 dramatically reduced the value of the FRS Pension Plan assets from about $135 billion to under $100 billion. As a result, politicians embarked on a cost cutting spree that effectively reduced your retirement benefits. The effect of these changes on employees depended on whether they were in the Pension Plan, DROP or the Investment Plan. These changes still remain in place despite the improvement in state finances and the value of Pension Plan assets returning to over $160 billion as of June 30, 2018.
The single biggest change was the requirement for all state employees to contribute 3% of their salary to the Florida Retirement System. For those in the Investment Plan, these monies go into their own account. For those in the Pension Plan, those monies go into the general fund of the Pension Plan. This required contribution did not apply to those employees who were currently on DROP. This required contribution continues to effectively act as a 3% reduction in one’s salary. For most employees that was particularly tough to take over the past few years given the absence of any salary increases.
Meanwhile, the biggest change for those under the Pension Plan was the effective elimination of the Cost of Living (COLA) of 3% per year that is part of the calculation of one’s Pension Plan benefit.
While the original legislation stipulated that this was a five year suspension ending in 2016, by requiring legislative action to bring the COLA back, it effectively served as an elimination of this benefit. To date, there has been no real movement by the Florida Legislative to reinstate the COLA for state employees. Given that the value of the Pension Plan assets have returned to a value greater than what they were before the 2008-2009 financial crisis, the COLA benefit should arguably return.
The effect of this change is to prorate an employee’s COLA benefit across their total number of service years. For example, if you have 25 years of service as of July 1, 2011 and worked another 5 years, your COLA benefit under the FRS Pension Plan would decrease to about 2.5% per year from the current 3%. Similarly, if you plan to retire in 2020 with 25 years of service, you would have 9 years at a COLA of 0% (the years since 2011) and 14 years at a COLA of 3%. This would average out to produce a COLA of 1.7% on your pension in retirement.
Employees who choose to go on DROP are also affected by these legislative changes as well. Prior to 2011, DROP monies earned a guaranteed rate of return of 6.5%. After 2011, this rate dropped dramatically to just 1.3%. Over the five year DROP period, this 5.2% annual differential has a dramatic effect on reducing DROP values. In fact, employees should compare the impact of the additional years of service time on their pension with this more limited benefit of DROP. In some cases, the additional years increase one’s pension benefit more significantly than the potential income from the lump sum DROP amount. Remember, years spent on DROP don’t count towards calculating your pension benefit.
Investment Plan members were able to escape the effect of the 2011 legislative changes but in 2012 politicians caught up with them. In 2012, House Bill 5005 reduced the contribution paid by employers into the Investment Plan by a huge margin. Prior to July 1, 2012, the total contributions to one’s Investment Plan account was 22% for special risk employees and 9% for regular class employees. After July 1, 2012 those contribution rates declined to 13% and 6.3% respectively. Since then, these contribution rates have increased only slightly to 15% for special rate employees. Unfortunately, for regular class employees the contribution rate has further declined to 6%. These rates include the mandatory 3% employee contribution.
While billed as a necessary change to level the benefits between the Pension Plan and the Investment Plan, it served to disproportionately undermine the benefits of the Investment Plan. In addition, these changes in contribution rates were buried in legislation that was passed at the 11th hour and largely occurred without much discussion with the affected employees.
Of course, the deal is also different for new State employees as well. For those entering FRS employment on or after July 1, 2011, the vesting under the FRS Pension Plan increased to 8 years from 6 years. Vesting under the FRS Investment Plan remains at one year. In addition, average final compensation under the FRS Pension Plan increased to the 8 highest years of service from the 5 highest years.
The age eligibility for retirement increased from age 62 to age 65 for regular class and from age 55 to age 60 for special risk. The retirement eligibility based on years of creditable service increased from 30 years to 33 years for regular class and from 25 years to 30 years for special risk. New FRS employees will need to work longer in order to receive comparable benefits available to current FRS employees.
In addition, new employees must make an election between the Pension Plan and the Investment Plan within eight months after their hire – otherwise the state will choose for them! Effective January 1, 2018 if new employees do not make an election by the end of the election period of eight months, there will be a default membership. Employees in classes other than the Special Risk Class will default to the Investment Plan and members in the Special Risk Class will default to the Pension Plan. All members will continue to have a second election but employees should make their first election immediately after their hire. Otherwise you may wind up using your second election to reverse a default decision that you didn’t intend to make.
The bottom line on all these changes is that it affects your decision and timing on making any changes to your retirement. In the past, when employer contribution rates to the Investment Plan were 30% higher, the timing of any switch to the Investment Plan was somewhat immaterial. Now, the timing of the switch really matters. Over the years we have reviewed countless individual comparisons and while each situation is unique, based on these reviews, it seems that any move to the Investment Plan needs to be either at the inception of your career or at the end. This also preserves your second election to switch among the FRS options for future use as well.
At the beginning of your FRS career you have time to generate a sufficient balance in your Investment Plan and can take advantage of its shorter vesting requirements. In fact, we have seen some scenarios of late where employees who had initially started with the Investment Plan had the opportunity after 10-15 years to buy back into the Pension Plan and retain a significant portion of their Investment Plan balance.
In contrast, those that wait to switch at their 25th year of service (30 years if not special risk) experience the largest run up in their projected lump sum balance in the last five years of service. After hitting these full retirement service years, the projected balance rises at a rate similar to inflation. In those cases, it may make sense to make a move in that 25th (or 30th) year of service if an employee wants to go into the Investment Plan. The hardest scenarios are those with 15 years or so of service. For them, it probably makes sense to just wait things out before considering any move among the FRS options.
In addition, those retiring under the FRS Investment Plan need to be aware of the timing restraints that exist to access your money. Retirees must wait one full calendar month after the month in which they retire before they have an early access opportunity to draw funds from the FRS Investment Plan. In order to shorten this window, one should retire at the end of the month rather than the beginning of the month. For example, if you work a few days at the beginning of a month, you would have to wait the rest of the month plus all of the next month before getting any access to your FRS Investment Plan. This early access is also limited to just 10% of the balance and is available only to retirees who meet the normal age and years of service retirement parameters. In order to gain full access to their Investment Plan balance, retirees then have to wait another full two months after the early access period. Consequently, it often amounts to over three months before retirees can set up normal retirement income from their accounts. This is a significant issue with retiring under the FRS Investment Plan and retirees need to consider their timing restraints and plan their finances accordingly in order to have enough resources to bridge those first three months of retirement.
The FRS Investment Plan option started in 2002. The Investment Plan is a defined contribution plan in which employer contributions are a set amount as defined by law. The period of time in which the Investment Plan monies actually become yours or vest is only one year. The 3% employee contribution is still required but those monies go directly to your own personal Investment Plan account rather than to the general FRS fund. The amount of your retirement income depends directly on the performance of your Investment Plan account balance. Unlike the FRS Pension Plan, there is no fixed benefit level at retirement with the Investment Plan.
The Investment Plan is funded through defined employer contribution rates based upon your salary and your FRS membership class. The contribution rates are currently at 6% for regular class and 15% for special risk class which include the mandatory 3% employee contribution. These contributions are made every pay period to your own personal Investment Plan account. Prior to July 1, 2012, these contributions were 30% higher but this reduction occurred to level the Investment Plan benefits with prior cuts that were made in 2011 to the FRS Pension Plan benefits. Regardless, it is disappointing to have any cuts to contribution rates especially in this time of stagnant salaries.
In addition, these cuts in the contribution rates often mean that the timing of any decision to switch from the Pension Plan to the Investment Plan should be carefully considered. The second choice service on www.myfrs.com allows you to calculate different scenarios for when your lump sum balance is maximized. Often this occurs after you have completed your required years of service for full retirement (i.e. 25 years as special risk and 30 years as regular class for those hired prior to July 1, 2011). After that, if you are still working, the lump sum benefit amount does not increase that much at all. The other alternative is to choose the Investment Plan at the inception of your career with the state. We often see examples where this leads to a greater amount of money than the lump sum amount available on a subsequent conversion from the Pension Plan.
The Investment Plan contributions are sent to your personal account within the FRS Investment Plan. Within this account, there are only 21 different investment choices (10 of which are target date funds) to invest your contributions. While these choices are somewhat limited in number, there are some worthwhile investment options. We monitor the performance of the investment options we recommend within the FRS Investment Plan and let you know if any changes are warranted through our regular correspondence. Remember the overall balance in one’s FRS Investment Plan account is solely dependent on how your underlying investments perform.
In addition, when you retire, this account needs to follow a growth and income approach to provide you with a monthly retirement benefit like what you would have gotten under the Pension Plan. This means that you cannot treat the Investment Plan like a cookie jar in retirement by taking chunks out of the balance. The objective with the Investment Plan balance is to generate a regular monthly income by using a diversified and properly allocated investment approach. This is where our firm provides its greatest assistance to state employees by working together at retirement to establish a financial plan for the rest of their lives.
In summary, the Investment Plan provides you an option to personally control your retirement monies. Your years of FRS service are represented entirely in a cash value lump sum. The beneficiaries of this lump sum can be your spouse or children when you pass. However, this lump sum must be used to generate your retirement income. It does not come with any guaranteed benefit like the Pension Plan. For a more complete description of the FRS Investment Plan, please refer to the Summary Plan Description of the FRS Investment Plan prepared by the State of Florida Division of Retirement located within www.myfrs.com.
For a complete comparison of the advantages and disadvantages of these FRS options, please refer to FRS Plans Advantages and Disadvantages prepared by the State of Florida Division of Retirement at www.myfrs.com. In addition, we are here to meet with state employees at any time at no charge to discuss these options.
DROP is a program that allows you to retire without terminating your employment while your retirement benefits accumulate in a separate account earning 1.3% as of July 1, 2011. Previously, the earnings rate was 6.5%. In essence, you retire under the FRS Pension Plan and then have the ability to aggregate a lump sum cash benefit. At the end of your DROP period of 5 years, you must terminate employment. For a more complete description of DROP, please refer to the Frequently Asked Questions about DROP prepared by the State of Florida Division of Retirement available within www.myfrs.com.
DROP is not extra money or some kind of bonus. It is simply holding your pension check while you are continuing to work for the State. DROP participation means you retired under the FRS Pension Plan based upon your years of service at the time you elected DROP participation. By retiring at that time, your subsequent retirement benefit that would accrue over the next five years is set aside in a lump sum payment. However, your monthly check that you receive from the FRS Pension is less than it would be since the five years you spend in DROP do not count for the FRS Pension Plan calculation. In addition, the earnings rate on these DROP monies has been reduced from 6.5% to 1.3%. This drop in interest rate really undermines the value of DROP particularly considering that your years in DROP don’t increase your benefits under the Pension Plan.
The DROP balance should be rolled over to either the FRS Investment Plan or an Individual Retirement Account (IRA) upon leaving the state’s employment in order to properly manage taxes and retirement income. This rollover should be done properly in order to avoid full taxation of the lump sum amount. As you use this DROP amount to provide retirement income, regular income taxes will apply. By using an IRA you set the proper tax withholding rather than being subject to the 20% mandatory withholding that applies for direct DROP or FRS Investment Plan withdrawals.
However, if you are under the age of 59½ at retirement than you want to roll your DROP over to the FRS Investment Plan if you plan to use your DROP monies over time. Assuming you meet certain parameters (over age 50 and special risk or over age 55 and regular class), you are able to avoid the 10% penalty for early withdrawal by drawing directly from DROP. Alternatively, you could use the FRS Investment Plan (if over age 55) to provide penalty free access to these DROP monies over time. A major distinction between DROP and the FRS Investment Plan is that the DROP rules specifically recognize the age 50 public safety employee exemption as an exception to the normal 10% early distribution penalty. Meanwhile, the FRS Investment Plan does not specifically recognize this age 50 exception and only provides for the usual age 55 exemption. This is where your age, your job and where your money winds up starts to really matter if you want to reduce your taxes in retirement.
The oldest retirement option within the FRS is the Pension Plan. The Pension Plan is a defined benefit plan where your benefit of a monthly retirement check is defined by law. The amount of this check is determined by your years of service, your creditable service percentage and your average final compensation. In addition, you select from among four different options for your retirement income. The two most popular options are Options 1 and 3. Option 1 generates the most amount of income but ends when you die and Option 3 generates income for you and then your spouse when you die but with a reduction in income over Option 1 of typically 15-20% depending upon the age of your spouse.
This retirement income amount is annually supplemented in retirement by the application of a cost of living adjustment (COLA). However, the COLA has been suspended effective July 1, 2011 which results in a reduction of the prior COLA benefit of 3% per year. Despite better finances in Tallahassee, there has been no suggestion about reinstating this COLA in the future. Consequently, the COLA continues at 0% for all years of services after 2011. For retirees under the Pension Plan, your COLA in retirement is calculated by adding the number of years at 3% to the number of years at 0% and then dividing by your total number of years as a state employee. This average then becomes your COLA that will be permanently applied to your pension check in retirement.
Effective for new employees after July 1, 2011, retirement eligibility has increased to age 65 or 33 years for regular class and age 60 or 30 years for special risk class. Previously, normal retirement was age 62 or 30 years for regular class and age 55 or 25 years of service for special risk class. The vesting period for the Pension Plan has also increased from six to eight years for new employees hired after July 1, 2011. In addition, a 3% employee contribution is required that goes into the general Florida Retirement System. This effectively serves as a 3% reduction in employee compensation.
For a more complete description of the FRS Pension Plan, please refer to the Frequently Asked Questions about the Pension Plan and the Pension Plan Summary prepared by the State of Florida Division of Retirement. Both of these documents can be found within www.myfrs.com.
In summary, the FRS Pension Plan is a traditional check a month retirement plan. This check is guaranteed by the state to last for your lifetime or, with a reduction in income, for a set period of time or the life of another like your spouse. There is never any ability to utilize lump sum amounts from the Pension Plan nor leave a legacy to your beneficiaries. For some, this is the appeal of the Deferred Retirement Option Program (DROP).
A few years ago, we wrote a booklet describing the various retirement options to the state of Florida employees. We recently updated this booklet, The State of Your Retirement Third Edition by Joel J Garris. Over the next few weeks we will be posting individual chapters as a blog post. If at any time you would like a completed copy of the booklet, you can download it from our website at https://www.nelsonfinancialplanning.com or call the office at (407)629-6477 for a printed copy.
The purpose of this booklet is to provide a single source resource to state employees who are nearing retirement. If you are a member of the Florida Retirement System (FRS), you have seen a lot of changes to your retirement options over the past few years. The state of your retirement has changed dramatically and what made sense in the past often does not make sense today.
We regularly meet with state employees to help them figure out these ever changing options. These meetings generally focus on reviewing the pros and cons of your retirement choices to help you make an informed decision and are done as a free service to you. To learn more about us, please review the section “What Makes Nelson Financial Planning Different?” on page 35 of this booklet.
While you are working, we keep you informed on a continuous basis by mailing FRS Update letters every few months or so. We do not charge for this ongoing service. Simply put, keeping you informed about the latest legislative changes and market performance while you are still working is somewhat straightforward. It also gives you an opportunity to try us out before you’ll really need us in retirement.
As a current employee, your options have changed a lot since 2008. These changes fundamentally shift your retirement options. Be sure to read the section on page 15 entitled “Shifting Sands for Current Employees – The Litany of Changes since 2008”.
Once you retire, things get a lot more complicated. Our focus shifts to providing personalized retirement income strategies to meet your unique retirement expenses and tax liabilities. These income needs are ever changing and the tax implications in retirement are very important. There are a variety of accounts available as a state employee and each has different tax implications depending on your age and job. Your investment focus also shifts to a more growth and income oriented mix which is very different from the approach used while working. Simply put things get a lot more complicated in retirement and that’s when our customized advice applies. Be sure to read the section on page 27 entitled “Retirement Income – Your Age and the Account Matters.”
This third edition of the booklet not only updates your retirement options within the Florida Retirement System but also adds a separate chapter on two important topics not previously discussed. First, there is a chapter now on deferred compensation or 457 plans. These accounts are funded solely from your pay check and provide flexible options for usage in retirement. Second, the chapter on the Health Insurance Subsidy details this often forgotten benefit of being a state retiree. This is a valuable benefit that helps to offset the growing cost of health insurance and is available to every retiree regardless of whether they retire under the Pension or the Investment Plan.
Welcome to the back half of 2019! Market performance in the first half of the year was the best since 1999. The second quarter was driven largely by the market upswing last month which was the best for a June since 1955!
The main driver of these results is the 180 degree pivot at the start of the year by the Federal Reserve from raising rates to suggesting rate cuts. Everybody (and certainly the markets) always loves cheap money – the ability to borrow at historically low rates fuels economic activity and keeps inflation low. When combined with historically low unemployment and a healthy consumer population, the current economic climate remains quite favorable.
This month also marks a milestone for the economy – officially making it the longest recovery (120 months) in U.S. history. Many media reports suggest that this length of time is the very reason that the current economic climate is doomed for a decline. Unlike humans though, economic recoveries don’t die of old age – they die from excess growth and economic imbalances. The current expansion has certainly been nothing to brag about in historic terms with its slow growth rate. In fact, at its current pace, the current run would have to last six more years to match the aggregate growth of 1991-2001 and nine more years to match the growth of 1961-1969. Given that back drop, we believe that the current slow growth economic climate will remain favorable for some time to come. Besides a Federal Reserve well attuned to keeping the party going with low rates, let’s not forget years three (this year) and four (next year) of a Presidential cycle are historically strong as well.
Are there any clouds forming on the horizon that we should pay attention to? Well, certainly the debt load of our government and other countries around the world is most concerning. Unfortunately, politicians don’t seem to want to address such a problem these days – that’s a real issue for future generations! In the more immediate term, the markets are almost expecting a rate cut later this month – beware if that doesn’t happen as the markets will react very strongly!
Regardless of what happens in the immediate future, our advice is the same as it always is – especially when one owns well diversified and balanced investments. Stay consistent and don’t get too caught up in the headlines – be they positive or negative. However, if you know you need a chunk of money for something in the next few months – a trip, a car or college tuition (that bill to Auburn for my oldest son is due next month!) – now is as good a time as any to take it.
Remember, for weekly updates and information, tune into our radio show/podcast. The radio show broadcasts live every Sunday at 9AM on 93.1 FM/540 AM and then debuts on the various social media channels like Facebook https://www.facebook.com/NelsonFinancialPlanning/ and our website https://www.nelsonfinancialplanning.com
From a December to Forget to a 2019 to Remember (so far!), the markets have shown once again how difficult it is to predict their movement in the short term. January and February are in the books as the strongest start to a calendar year in over 30 years. This helped to repair much of the damage you saw on your fourth quarter statement of 2018. Be sure to open your first quarter statement of 2019 that you will get in about three weeks or so to see the improvement!
We have the Federal Reserve to thank for this quick market turnaround. Their decision to shift from raising interest rates to holding them steady sparked this market improvement. Going forward, we believe there are enough positive economic indicators to continue this positive market movement albeit not as quickly as what we saw in the first two months of the year. Corporate profits are still at historically high levels with companies reporting profit increases of over 13% for the most recent quarter. Unemployment levels are still at historical lows while wage growth (and correspondingly consumer spending) have started to pick up.
Despite this positive economic news, all the conversation in the media is that the next recession is just around the corner. Well, let me remove some of the mystery on that – a recession will absolutely occur in the future – they are after all a normal part of the economic cycle. If you are age 65 today, then you will most likely see 3 or 4 more recessions in your lifetime. The unknown question of course is – when will that recession occur? With the current economic data and interest rate climate, it is hard to imagine that a recession is imminent in 2019. Speculation that Brexit, trade policy with China, or increased tension with North Korea might accelerate that timing is just that – speculation. Regardless, given the lower levels of borrowing and higher levels of cash holdings in the current economic cycle, we believe the next recession will be somewhat mild – much more like a 1990 type recession than a 2008 one.
So what should you do to prepare for the next recession? Well, your job is to stay calm and maintain perspective. Things are never quite as bad as the media makes them out to be. Our job is to make sure your accounts are well balanced and broadly diversified and that your investments are some of the best available. On that front, the annual ranking of fund companies by Barrons came out last week and American, MFS and Putnam all placed in the Top 10 for either 5 year rankings or 10 year rankings. American Funds in fact garnered the title of the best fund family for 2018 based on the overall performance of its funds.
Tax season is in full swing at the office these days and certainly all the tax changes for this year are producing a range of results. Our capacity this year is much greater than last because we have added a full-time CPA to the team. Kristin Kalley joined us in early February. Previously, Kristin worked for a global accounting firm but more importantly, years before that, she was an intern at our office! Her addition at the office provides us with not only the capacity to do more tax returns but also to visit with folks during this time of year on non-tax related matters as well. So don’t hesitate to come in for a conversation at any time!
Look forward to seeing you soon!
There are so many tax changes for 2019 that we needed to double our normal Top 10 list! The Tax Cut and Jobs Act (the “Tax Act”) enacted at the end of 2017 produced sweeping changes to tax rates and deductions for both businesses and individuals. These tax changes will finally have their full impact on the 2018 tax return. Most of these changes are only in effect until 2025 when the prior rules and rates return. If you have any questions about the effect of these tax changes on your personal situation, please contact us at 407-629-6477.
- Lower Income Tax Rates. While the Tax Act did not reduce the number of different income tax rates, it did lower nearly all of these rates typically by 3 full percentage points. For example, the top rate of 39.6% reduces to 37% while the 25% rate mostly shifts to 22%. The new rates are now 10%, 12%, 22%, 24%, 32%, 35% and 37%. These across the board cuts translate to an average estimated tax savings of $1,600 per household in 2018. Retirees may want to adjust their tax withholding to reflect this drop in taxes and workers may want to use these savings to more fully fund their retirement plans. Going forward, the brackets will be adjusted on a different inflation measure that is expected to grow more slowly than the previous inflation measure.
- Higher Standard Deduction (But No Personal Exemptions). The Tax Act increased the standard deduction from $6,350 to $12,000 for single filers and from $12,700 to $24,000 for couples. For 2019, these amounts increase to $12,200 for single and $24,400 for joint filers. An additional standard deduction of $1,600 for singles and $1,300 per person for couples is allowed for those that are blind or over age 65. The new standard deduction for Head of Household filers is $18,000. This change effectively reduces the need to itemize deductions and simplifies tax preparation for millions of Americans. Nearly 70% of taxpayers who currently itemize will no longer need to take those extra steps on their tax returns. However, the trade off to this higher deduction was the elimination of the personal exemption which amounts to a deduction of $4,150 for each person or dependent on a tax return.
- Higher Contribution Limits for 401(k)s, 403(b)s, 457s, Simple IRAs, IRAs & HSAs. The contribution limits to retirement accounts increases for 2019. For 401(k)s, 403(b)s and 457s the limit increases from $18,500 to $19,000. For those over age 50, the catch-up contribution limit remained at $6,000 allowing for a maximum possible contribution of $25,000 for 2019. The limit for SIMPLE IRAs increases from $12,500 to $13,000 with the over age 50 catch up contribution staying at $3,000. The annual limit on Traditional IRAs and Roths increases to $6,000 for 2019 from $5,500 for 2018. The age 50 catch-up contribution remains at $1,000 for these accounts. The Health Savings Account limits also increases from $3,450 in 2018 to $3,500 in 2019 for individual plans while family plan contribution limits increase from $6,900 to $7,000. In addition, HSA account holders age 55 and older may contribute an extra $1,000 annually. These increases reflect inflation adjustments on the contribution limits and allow tax payers to save more.
- Limits on Deductions for State and Local Income, Sales and Real Estate Taxes. Previously, taxpayers could fully deduct their real estate taxes plus either state and local income taxes or general sales taxes. Starting in 2018, the total amount of these deductions is capped at $10,000. This provision most negatively effects those individuals who live in states with high income taxes and high real estate taxes. Like many other provisions, this cap expires in 2025 so the old rules could return in 2026.
- Limits on Mortgage Interest Deductions. Starting in 2018, the maximum amount of mortgage debt that one can deduct the interest on reduces from $1 million to $750,000. This aggregate limit applies to the combined mortgage amounts for first and second homes. This change does not affect existing loans or future refinances of existing loans that don’t increase the amount owed. The impact of this change is somewhat minimal though as less than 4% of outstanding mortgages had balances greater than $750,000. However, this change also eliminates the ability to deduct interest on home equity loan balances unless these proceeds were used to buy, build or substantially improve a primary residence or a second home. On a positive note, the new law preserves the valuable break that allows taxpayers to avoid capital gains on the sale of a primary residence up to $250,000 for individuals and $500,000 for couples.
- Medical Expense Deduction Changes. For 2018, taxpayers can deduct unreimbursed medical expenses that exceed 7.5% of adjusted gross income. Unfortunately for 2019, this threshold increases up to 10%, effectively making the write off for medical expenses even harder. In a blow to Obamacare, starting in 2019 (not 2018), the Tax Act also permanently eliminates the penalty for not having health insurance.
- Limits on Itemized Deductions Suspended. For taxpayers who do itemize, they may wind up with more deductions then before. Previously, at certain income levels, the amount of itemized deductions was limited. Currently, this income limitation has been removed so taxpayers can deduct all of their itemized deductions.
- Other Itemized Deduction Changes. Casualty and theft losses are now deductible only to the extent they are attributable to a federally declared disaster. The limit on charitable contributions of cash increased from 50% to 60% of adjusted gross income. Most importantly the deduction for unreimbursed job-related expenses such as uniforms, union dues, and business-related meals, entertainment and travel plus similar deductions for tax preparation fees and investment expenses have all been suspended. Previously, these expenses were deductible to the extent they exceeded 2% of your adjusted gross income. Traveling sales people, airline employees and similar occupations will bear the brunt of this lost deduction.
- Expanded Child Tax Credit. The Child Tax Credit allows for a reduction in federal income taxes for each child under the age of 17 that is claimed as a dependent. The Tax Act doubles this credit from $1,000 per child to $2,000. In addition, up to $1,400 of this expanded credit can be refunded even if one doesn’t owe any income taxes. The number of taxpayers eligible for this credit also expands as the income eligibility thresholds increased from $75,000 to $200,000 for singles and from $110,000 to $400,000 for couples. There is also a new $500 non-refundable credit for qualified non-child dependents, such as elderly parents or older children, who are claimed on one’s tax return.
- Expansion of Alternative Minimum Tax Threshold. The Alternative Minimum Tax is a parallel tax system designed to ensure that high income earners pay a larger amount of taxes. However, in recent years, the AMT has begun to apply to many middle-class households because its threshold has not increased much. The Tax Act effectively expands the AMT threshold to the point that it is unlikely to affect families with incomes less than $1 million.
- Moving Expenses Write Off Changed. The deduction for moving expenses is also suspended. Consequently, those moving for work will not be able to deduct their moving costs unless they are members of the U.S. military on active duty. In addition, any moving amount reimbursed by an employer must now be counted as taxable income to the employee.
- Recharacterization Option Eliminated. Recharacterization of a previous Roth conversion is no longer allowed. Previously, one was able to undo a Roth conversion and avoid the tax bill if the recharacterization was done by October 15 of the subsequent year. Taxpayers should be absolutely certain of the tax impact of a Roth conversion before implementing one because now there is no opportunity to correct any miscalculations to avoid the corresponding tax bill of a Roth conversion.
- Corporate Tax Rates. The biggest change under the Tax Act is the permanent reduction of the corporate tax rate from 35% to 21%. This change puts the U.S. on equal footing with most other major economies that have reduced corporate tax rates over the past decade. This cut increased corporate earnings by nearly 10% in 2018 and will continue to be a further boon to equity investors. In an effort to encourage multi-national corporations to repatriate some of their overseas profits back to the U.S., a special one-time 15.5% tax rate now applies to those re-patriated dollars. Smaller companies that are typically pass-through businesses such as partnerships and S-corporations would also benefit from lower taxes by virtue of a deduction of up to 20% of their income. This deduction (referred to as a section 199A deduction) phases out at income levels above $157,500 for singles and $315,000 for couples for 2018. The deduction amount is calculated as a function of the amount of wages paid to the business owner.
- Energy Tax Credits. The tax credit for qualifying solar systems has been extended through 2021. This tax credit was originally scheduled to decrease from 30% of the value of a panel to 10% in 2017. The tax credit will now stay at 30% of value until 2019 before falling to 26% in 2020, 22% in 2021 and then 10% in 2022. Purchasers of such systems need to be mindful that such tax credits are not refundable, so one should not assume receipt of the full tax credit. A tax credit also remains for qualified energy efficient home insulation and exterior doors and windows. This credit is worth a maximum of either 10% of the cost or $500 and must be combined with any prior usage of this tax credit going back to 2006.
- Estate Tax Exemption. While not eliminating estate taxes, the Tax Act substantially increases the threshold where Americans would owe estate taxes at their passing. The estate tax exemption doubled from $5.49 million per person to $10.98 million in 2018. This change means that only truly ultra-rich estates would ever pay any estate taxes since a married couple could combine their exemptions to pass a total of nearly $22 million with no estate taxes. After doubling for 2018, the estate tax exemption increases even further in 2019 to $11.4 million per person. The annual gift exclusion (the amount you can give to somebody with no reporting requirements) remains at $15,000.
- Alimony Payments. Starting in 2019, the deduction of alimony payments will not be allowed, and recipients would not need to report alimony received as income. This is a significant change that will affect the outcome of most divorce proceedings. In effect, this should reduce the actual amount of alimony payments since there is no tax benefit for the payor.
- Education Related Deduction. The education expense deduction of $250 per year for unreimbursed classroom supplies also remains along with the ability to deduct student loan interest up to $2,500. 529 plans can now be used for K-12 expenses up to $10,000 per year of tuition. Previously, such plans could only be used for post-secondary educational expenses.
- 401(k) Loan Payment. Under the new law, people who leave a company with a 401(k) loan outstanding would be able to repay the loan by the day they file their federal tax returns and avoid any and all taxes and penalties on the loan amount. This is a provision that adds flexibility for taxpayers and gives them an opportunity to avoid any applicable taxes and penalties.
- RMD to Charitable Organizations. Individuals over age 70½ who must take Required Minimum Distributions from their retirement accounts can make those distributions tax-free directly to charitable organizations. This allows taxpayers to get the tax savings benefit of a charitable contribution without having to itemize. Taxpayers who still want to make charitable contributions and get a direct tax deduction for them should take advantage of this provision.
- Capital Gains & Dividend Tax Rates. The Medicare/Obamacare Tax of 3.8% on dividends and capital gains remains. This additional tax applies to investment (unearned) income for single filers with income above $200,000 and married filers with income above $250,000. Investment income includes dividends, interest, rents, royalties and capital gains. For individuals earning more than $425,801 or couples earning more than $479,901, the long-term capital gain and dividend rates are at 20%. However, most taxpayers will be subject to rates that are either at 0% for those in the 10% or 15% ordinary income tax brackets or 15% for those in higher income tax brackets. These tax provisions still demonstrate a tax policy preference for dividends from stocks over interest from bonds, CDs or savings accounts.
The legal and tax information contained herein is merely a summary of our understanding and interpretation of current tax laws as of January 1, 2019 and is not exhaustive. Where indicated, past performance is not a guarantee or indication of future performance. Nelson Financial Planning, Inc. offers securities through Nelson Ivest Brokerage Services, Inc., a member of FINRA, MSRB and SIPC.