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What the House Tax Bill Could Mean for Investors

Morningstar's director of policy research, Aron Szapiro, gives his first take on the impact of the proposed tax bill.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We got the House's tax bill this morning. I'm here with Aron Szapiro, he's our director of policy research, for his first take at what investors should be looking out for. 

Aron, thanks for joining me.

Aron Szapiro: Thanks so much for having me.

Glaser: Let's talk a little bit about this bill. I know we just got the text of it. One of the notable things was what wasn't in it, which is changes to the 401(k) plan.

Szapiro: Yeah, that's right. There've been a lot of rumors that there would be what we termed "Roth-ification." That is directing some or maybe all due contributions, employee contributions to 401(k) plans into Roth-designated accounts. You can kind of see the appeal of this, from the perspective of the architects of tax reform. It would generate revenue over the 10-year budget scoring window that they used to calculate the effects of the bill, and of course create the decline in future revenues, since the money would be withdrawn tax-free. 

We had some concerns about this. When you model this out for prototypical middle-class people, it's not always that good a trade and it might not work out that well. Of course there are big behavioral questions around how people would react to paying taxes up front on their 401(k) contributions. At least for now, that provision did not make it into the first cut of the bill.

On the other hand, many of the things that did are not without controversy. I don't think we've seen the last of this "Roth-ification" idea, going forward.

Glaser: Let's look at one of those controversial provisions, which are some big changes, potentially to the mortgage interest deduction. What do you think that will mean for investors?

Szapiro: I want to just start off by saying the cap on the mortgage interest deduction, which is currently on loans up to $1 million and would be reduced to $500,000, is actually something of a red herring here. The really big action is around changes to the standard deduction, which would in turn, make it much less likely most people would be able to claim the mortgage interest deduction. Just to sort of go through that really quickly, the bill would almost double the current standard deduction for a married couple from $12,700 to $24,400, and it gets rid of the personal exemptions to do this. This ends up being a wash, depending on family size, and then there's some enhanced child tax credits to kind of make people whole.

However, that, combined with getting rid of all of the state and local tax deductions, except for property taxes, creates a pretty narrow band of people who could plausibly itemize their deductions because they'd have a much higher standard deduction that would be higher than the itemizations they could put together. I think that's actually the more important part of the change. It's sort of subtle, but it does really reduce the number of people who could itemize at all, and thus get the mortgage interest deduction. And it reduces the value of that mortgage interest deduction and other itemizations, vis-a-vis the standard.

Now in terms of how that affects investors, the fact is that people's homes are the biggest investment many people have. With 401(k) savings usually coming in at number two. I think it's pretty fair to say that at least some of these tax benefits are baked into the housing market. I think you would reasonably expect that house appreciation would slow. House values might decline with this change. Of course, we'll have to see how that all plays out. It is a really substantial change in the incentives people have to buy a home and to have a mortgage to pay for that home. It's not just this reduction and the cap. It's sort of the overall changes to the standard deduction and who can plausibly end up claiming it, or end up itemizing.

Glaser: The bill presents some pretty big changes to business taxes, as well. For individuals, how should they think about this? Is any of this pass-through, something that's relevant and you should be keeping an eye on?

Szapiro: Most companies are not organized as C corporations that pay corporate business tax. Obviously, the large companies are and, I guess, generate somewhere around 10% of total tax revenues. But most companies, 90% plus, are organized as pass-through entities. I'm sure many of our listeners, and people who read own small businesses that are organized that way. It does look like that might give people a pretty substantial tax break, although it's a pretty complex idea that makes a distinction between passive owners of pass-through businesses and active owners who are sort of collecting something that looks more like wages.

I think the really important thing to keep an eye on here, from the perspective of retirement security, it's sort of an irony of all this discussion is that to the extent that we use the tax code to encourage businesses to provide programs that are a social good, healthcare and retirement benefits particularly, any reduction in the marginal brief, could act as a disincentive to offer plans. My first read on this is, this is probably not a big enough change to really do that, but it is the case that if somebody used to face a pass-through tax rate of 39% and now it's lower, they might be less incentivized to head up a plan because they personally benefit a little less. We'll have to do some more analysis on that in the coming days.

Glaser: Aron, thanks for your first take. I know there's a lot of moving parts here, and this bill will evolve before it becomes law, if it does become law, but we appreciate you taking the time today.

Szapiro: Absolutely. My pleasure.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.