The Tax Reform Act of 1986
The Tax Reform Act of 1986: The law that still rules your retirement
Forty years ago this month, in October 1986, President Reagan signed a sweeping piece of legislation that completely rewrote the rules for your money. If you own an IRA, contribute to a 401(k), or file a tax return, you are still living with the massive ripple effects of the 1986 Tax Reform Act today.
At first glance, the Tax reform Act looked like a massive win for simplicity. It collapsed a complicated web of 15 different tax brackets down to just two: a 15% bracket and a 28% bracket. For top earners, watching the highest marginal bracket drop from 50% down to 28% felt like an incredible break.
But in Washington, nothing comes without a trade-off. The Tax Reform Act was no exception.
Because the Tax Reform Act was required to be “revenue neutral,” those dramatic rate cuts had to be paid for somehow. To foot the bill, lawmakers targeted popular deductions, killed off entire investment structures, and fundamentally altered how Americans save for retirement.
Here are a few major ways that the now-40-year-old Tax Reform Act is still dictating your financial reality today:
1. The Death of the Tax Shelter Industry
Before 1986, long-term capital gains enjoyed a 60% exclusion, meaning you were only taxed on 40% of your investment profits. The Tax Reform Act ended that break entirely, pushing the top rate on gains to 28%.
At the same time, new “passive loss rules” put an immediate end to using paper losses from limited partnerships to wipe out regular taxable income. This single change effectively wiped out the massive limited partnership industry, which had been a goldmine and major profit center for brokerage firms. It also stretched out depreciation schedules for real estate rentals, helping trigger the real estate slump of the late 1980s.
2. New Hurdles for Retirement Accounts
If you think retirement account rules have always been this rigid, think again. The 1986 Act extended the 10% early withdrawal penalty (for distributions before age 59½) from IRAs over to 401(k)s and employer plans. It also established a uniform set of Required Minimum Distribution (RMD) rules starting at age 70½. Missing an RMD back then carried a staggering 50% penalty—a rule that was only recently brought down to 25%.
Furthermore, pre-tax contribution limits for 401(k) employees were slashed from $30,000 down to just $7,000.
3. The Birth of Form 8606
Perhaps the most frustrating legacy of the 1986 law for modern savers was the restriction on IRA deductions. The bill stated that if you had access to a workplace retirement plan, you could no longer deduct your traditional IRA contributions.
This change gave rise to the non-deductible IRA and, subsequently, IRS Form 8606. Decades later, “tracking your basis” on these accounts remains one of the most common tax traps that consistently trips people up when they prepare to withdraw their money.
4. Everyday Deductions Disappeared
The law didn’t just target investors; it hit everyday household budgets. It eliminated popular write-offs like the deductibility of interest on credit cards and car loans, and it removed the state sales tax deduction. Because mortgage interest remained deductible, home equity loans suddenly skyrocketed in popularity as homeowners scrambled to find a new way to write off debt.
Even kids weren’t exempt. The “kiddie tax” was introduced to tax a child’s investment income at the parents’ higher rate. The law also began requiring Social Security numbers for dependents age five and older. Fun tidbit: in 1987, the year after the law passed, seven million fewer dependents were claimed on tax returns than the IRS expected. Many of those dependents likely never existed on anything but paper!
Rules Change. And Your Strategy Has to Adapt.
Lawmakers pushed these changes through because they were worried that pre-tax retirement accounts were an expensive break that primarily benefited high earners. To even the playing field, they tightened non-discrimination tests to compare what rank-and-file employees could contribute versus executives.
We have been navigating these exact rules for four decades. But as history shows us, Washington loves to rewrite the playbook. In our next video and post, we’re going to discuss the exact opposite side of this coin: why your current retirement strategy can’t always rely on today’s rules staying the same forever.
Links for The Tax Reform Act of 1986
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Watch this episode (“The Tax Reform Act of 1986”) on our YouTube Channel
The 1986 Tax Reform Act itself: Congress.gov summary of H.R. 3838 and Reagan’s signing remarks
Tax brackets over time: Tax Foundation bracket history
The 60% capital gains deduction and the 6-month holding period from 1984 to 1987: Congressional Research Service history of capital gains taxes
Today’s capital gains rates: IRS Topic 409 and IRS page on the 3.8% investment income tax
Passive loss rules: IRS Publication 925
Nondeductible IRAs: IRS Form 8606
Kiddie tax: IRS Topic 553
Backup withholding: IRS backup withholding page
The 7 million missing dependents: Los Angeles Times (1990), Seattle Times (1990), NBER study and Social Security Administration history
Transcript for The Tax Reform Act of 1986
40 years ago this month, October 1986, President Reagan signed a law that rewrote the rules for your IRA, your 401(k), and your tax return.
You’re still living with a lot of these changes today!
For starters, the tax rates got simpler.
And lower, a lot lower.
15 different tax brackets became just two, the 15% bracket and the 28% tax bracket.
The top tax bracket dropped from 50% to 28%, a massive move announced for 1988.
1987 was a phase-out year.
By the way, if you’re new here, my name is Tom Mullooly.
I own a financial planning and investment firm here in Wall Township, New Jersey.
And I work alongside my three sons, who are all certified financial planners just like me.
So the trade-off for simplifying these tax brackets?
A lot.
In fact, most deductions and loopholes had to go away – to pay for that.
For example, capital gains and tax shelters were changed.
In fact, the tax shelter industry pretty much just went away.
More on that in a moment.
The 60% exclusion on long-term gains ended, so gains were taxed a little more like regular income.
Before 1986, you paid tax on only 40% of a long-term gain.
But the tax bracket was 50%, so the top rate worked out to about 20%.
The 1986 Tax Reform Act (law) ended that break.
So the entire gain became taxable.
And so the top rate on gains went to 28%.
Yes, lower tax brackets, but a bigger bite on investment gains.
With limited partnerships, the passive loss rules ended the practice of using limited partnership paper losses to wipe out or offset taxable income.
That was a good gig, but it was now over.
It pretty much wiped out the entire limited partnership industry.
This had been a huge, huge profit center for brokerage firms.
And then longer depreciation schedules for real estate rentals helped set up that slump that we saw in real estate in the late 1980s.
They changed retirement accounts in the same Tax Reform Act in 1986.
The 10% early withdrawal penalty before 59 and a half (which IRAs already had), this was now extended to 401Ks and other employer retirement plans starting with the Tax Reform Act.
Also, there was now going to be one set of required minimum distribution rules (RMDs), for all plans starting at age 70 and a half….. with a 50% penalty for missing one.
That 50% penalty was only changed a few years ago.
Now it’s 25%.
The 401(k) employee’s pre-tax contribution limit was cut from $30,000 to $7,000.
Deductions on IRA contributions were limited.
If you had a workplace retirement plan, you, you couldn’t deduct the IRA contribution anymore.
By the way, this change gave rise to non-deductible IRAs and Form 8606.
And why “tracking your basis” still trips people up today.
Some other things, everyday deductions that disappeared:
Interest on credit cards and car loans stopped being deductible.
State sales tax was no longer deductible.
Home equity loans became popular because mortgage interest stayed deductible.
What about kids and taxes?
With the kiddie tax that was implemented, a child’s investment income could now be taxed partially at the parent’s rate.
An interesting tidbit, starting with the Tax Reform Act, Social Security numbers were required for dependents age five and older.
Prior to that, you only needed to provide the dependent’s first name, no Social Security number.
And so in 1987, about 7 million fewer dependents were claimed than the IRS expected!
Many of these dependents – probably – never existed.
What about business taxes?
The top corporate rate fell from 46% to 34%, and the investment tax credit was repealed.
Why all the changes in one tax bill?
The bill had to be revenue neutral, meaning the big cuts in taxes and tax brackets had to be paid for by closing tax breaks elsewhere.
And pre-tax retirement deferrals, you know….. contributions to retirement plans on a pre-tax basis were an expensive break.
Second, lawmakers were concerned that 401(k)s mostly benefited higher-paid employees….. who could afford to defer larger amounts.
That same law also tightened the non-discrimination tests….. which compare how much highly paid and rank and file employees put into the plan.
Some of these rules have now been in place for 40 years.
Other rules have already been rewritten, and that’s the point of our next video next week…… why your retirement plan can’t always use today’s rules.
If you’re in Monmouth County or in central New Jersey, our office is right here, in Wall Township.
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