Take Action on These Tax Tasks Now

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The tax package is set to go into effect next year, but individuals in certain situations will want to take action in 2017 to reduce future tax bills. Joining me to share some tips on that front is Tim Steffen. He's director of advanced planning for Baird.

Tim, thank you so much for being here.

Tim Steffen: Thanks, Christine.

Benz: We had sat down a couple of weeks ago, and you made the point that as in the past, if you can accelerate your deductions and defer your gains, even though we didn't know at the time what the outlines of this tax package would look like, that those are generally good strategies to keep in mind. Sure enough, now that we do know what the tax package looks like, investors should keep those things in mind.

You brought a few things that you think investors should have on their radar, very time-sensitive things that they should be contemplating before the end of 2017. Let's start with some of the things that you think about in terms of accelerating deductions. First let's talk about why deductions will be less valuable starting next year for many taxpayers.

Steffen: There's really two reasons why we're concerned about this. One is in 2018, there will be fewer types of expenses that are deductible. Some of the ones that are still deductible will be capped--things like state income taxes and property taxes. There will be fewer itemized deductions, plus the standard deduction is going to be bigger next year. In general, we're going to see fewer people itemizing in 2018, meaning that they're going to get less benefit for their specific expenses like taxes or contributions or some of those types of things.

Benz: There has been this mad scramble for some people trying to prepay these taxes so they can take advantage of them, of the deductions, on their 2017 tax return. One of the big categories that people have been looking at is prepaying property taxes. Let's talk about that one. Who should take a look at doing that?

Steffen: I think I'd put it into two separate categories. If you're someone who has received your property tax bill this year, and you've got the option of paying it in December or paying it later, in early 2018, probably makes some sense to really think about paying it in December this year to make sure you lock in the full benefit of that deduction.

Other scenarios might be if your property tax bill comes later on in the spring or even in the summer, there's been some questions about should I call my local county or my local assessor and find out what my bill's going to be and try and send them a check now. I think there's some more uncertainty about that as to whether the IRS would allow a deduction like that. I would say, in general, if you've got your bill in hand, by all means, try and pay it this year, assuming you don't have AMT issues to worry about.

That's the big wild card with these two, with income taxes and property taxes. If AMT's not an issue, then you probably ought be looking at that, but let's talk more about that.

Benz: Let's talk about that, because AMT is in the mix with this tax package as well. Let's talk about deductions of property taxes and state and local taxes for people who are subject to the AMT and how that's changing.

Steffen: State income taxes and property taxes are two of the bigger things that tend to push people into AMT, because they're not deductible under that system. People who tend to pay a lot of taxes in that way, state and property taxes, tend to be more likely to an AMT. If you are an AMT, there's really no benefit to accelerating or paying any more this year than you absolutely have to. From a time value of money standpoint, keep your cash as long as you can. Pay the bills later since you're not going to be getting a tax deduction for them today.

The other thing to look at is, if you weren't an AMT, or you weren't planning on being an AMT, perhaps then you might think, great, I can accelerate some of these payments and pay those taxes this year. Just be aware, by making those extra payments that that might be enough to actually push you into AMT. In other words, you may not be there now, but if you pay enough taxes to try to accelerate the deductions, you might find yourself in there anyway.

Benz: I saw someone suggesting that you should actually pay more on your property tax than you otherwise would. Does that strategy make sense to you?

Steffen: Not on the property tax side. I can't imagine that the state would allow you to do that, and the county, and certainly the IRS isn't going to let you prepay a liability that if they're paid more than a liability than you know actually exists. In other words, you've got a fixed and determined liability. You can't pay more than that and get a deduction just because you wanted it.

People have said the same thing on the state income tax side, though. Should you overpay your state income taxes this year to get a larger deduction? I suppose there may be a room to do that, but keep in mind when that refund comes back to you next year, you're going to have to report that as income. It's not maybe quite the benefit you were thinking it is.

Benz: Another tip that you have is that people should look at what you'd call bunching charitable contributions. Let's talk about why that would be an advantageous strategy, certainly for the charitably inclined.

Steffen: For those people who typically itemize this year, I think we'll see fewer of them itemizing in the future because of the larger standard deduction and the loss of some of the income and property tax deductions. Again, if you're a charitably inclined person who does give a lot to charity, you might find you get less benefit from that in future years, because you're taking the standard deduction more often.

What you might want to consider is instead of giving those donations in 2018, and maybe even 2019, prepay those. Make those gifts in 2017. Now you may be hesitant to want to give a big gift to a charity today rather than spreading it out over a few years. That's where vehicles like donor-advised funds can be real handy as a strategy. Putting money into that, get the deduction today, and then spread the gifts out to the charities over the next couple of years.

This may be something that you do every few years, anyways. Find one year in which you want to get all your gifts into one calendar year so you can get the deduction then. Then on the off years, go back to using the standard deduction.

Benz: Bunch my charitable gifts together in a year where I know that I'll be an itemizer. Is that what you're saying?

Steffen: Basically, yes. Yes, so you figure maybe every other year I itemize, or every third year, I itemize. On the off years, I take the standard deduction.

Benz: Another point you had is that if you have a mortgage, that you consider accelerating your January payment, maybe making that January payment here in December. Why would I want to do that?

Steffen: Because when you make your payment in early January, a portion of that, perhaps even a big portion of that payment, is really going to be interest. If you pay that interest in December, you get that deduction in December. Interest is calculated on a daily basis, so the amount you pay in December of interest might be a little less than what you pay maybe later in January, but at least you get that portion of the deduction in this year. You can't pay any more payments than what you would already owe in January, but at least you get some acceleration of that interest deduction into this year.

Benz: One subtopic there is that home equity loan interest will no longer be deductible. You say actually, that's a category where if you have the wherewithal to do so, start getting rid of it, paying it down as aggressively as you possibly can.

Steffen: Correct. Those home equity loans are going to become more expensive in the future because you can't take a deduction for the interest. As you're trying to prioritize the paying off of debt, home equity loans may have just scooted up the list a little bit. You might want to pay those off sooner.

Benz: In the category of delaying gains, you have a couple of suggestions there. One, again, gets back to the alternative minimum tax, or AMT. You say that that's potentially an area where people would want to delay exercising those options and potentially pushing themselves into the AMT zone.

Steffen: Right, so if you're an executive or even an employee of a company where you've been granted incentive stock options, and these are the options that are typically most closely associated with AMT, as you exercise those, they create income for the AMT purposes only. If you do them this year, you're subject to the rules in place now. But if you push those exercises off into January, they'll still be income for AMT, but the AMT rules have changed dramatically next year.

The net result is that a lot less people should be subject to AMT in 2018 and beyond than what we're seeing in 2017. There's a bit of a time value thing you've got to be careful of. Is it better to exercise now or in the future from an investment standpoint? But from a tax standpoint, there could be some real advantages to deferring those ISO exercises into 2018 or beyond.

Benz: You say broadly speaking, taxpayers should consider if they have the ability to delay gains, to delay income and push it into 2018, that they should consider doing that. Why is that?

Steffen: I think if we're talking just primarily about income, not so much gains, the capital gains, but of income, so things like wages, bonuses, those types of things, if you have the ability to do that, in general, marginal tax rates are going to be lower in 2018 than they are in 2017. That income might get pushed into a little lower tax bracket next year.

Your employer may not be willing to do that, because the employer wants the deduction now. You want the income in next year, so there's a bit of a give and take there. Frankly, most employees, most working people, don't have the ability to time the recognition of their income. We're really talking about people who were maybe more commission-based, maybe some self-employed people who are doing their own billings. Maybe some of those types of things, you push out in 2018.

Benz: One tip you have relates to what is called an IRA recharacterization. Let's talk about that and why people who had their sights set on doing some sort of a recharacterization should get on the stick, because that won't be something they can do in 2018.

Steffen: Typically, if you did a Roth conversion during 2017, you have the ability to recharacterize that, which basically means changing your mind and taking the money out of the Roth, put it back in the traditional IRA. You have until Oct. 15 of the following tax year to do that, so Oct. 15 of 2018.

The new bill has essentially eliminated the ability to do Roth recharacterizations beginning in 2018. There's a little bit of uncertainty as to, does that apply to just conversions done in 2018? Or does it apply to conversions done in 2017, as well? We're taking the position that if you think you might recharacterize your 2017 conversions, you probably ought to do it now. Once this all shakes out, you may find out you missed your opportunity. I would say really look closely at that. If you think you might recharacterize, try to get that done here before the end of the year.

Benz: One important point on this recharacterization topic is that if you make a contribution to an IRA and you just goofed, you made the wrong type--maybe you earned too much to contribute to a Roth IRA, so you have to do a traditional nondeductible IRA instead--those types of mistakes can still be undone via what's called a recharacterization.

Steffen: Those can now still be done under the recharacterizations. One of the earlier proposals that we saw going through this whole process was that even those types of recharacterizations would not be allowed. That was cleaned up in the final bill, which makes sense. It's just simply an error in the type of contribution you made. That, you could still undo.

Benz: Now a couple of your last-minute 2017 to-do items related to this tax package have to do with kids. Let's talk about kiddie tax. What's going on there, what people should think about if they have investments in their children's names?

Steffen: Remember, the kiddie tax is a tax on unearned income of minor children. These are kids who have investment accounts or maybe even are beneficiaries of an IRA that they inherited from a grandparent. Maybe they're getting some Social Security benefits, something like that. Any kind of income that they received other than wages, that income in 2017 after you take a couple of minor exemptions off of that, is effectively taxed at the same income tax rate that the parents are.

Beginning in 2018, that's going to change. Now kids will become their own taxpayers for all of that income, but the income will be taxed as if it was income from a trust. If you're familiar with the trust tax rates, very, very condensed system. You get to the top rate at a trust at about $12,700 of income or so when you're at the top tax bracket. In some cases, this may mean more tax on unearned income for kids. But because you're pulling it off of the parents' return, if this is a child of a high-income parent who doesn't have a lot of earned income themselves, the child doesn't, it could be a tax savings by having it be taxed to the child directly now.

This is one of those where you're going to have to look at each situation differently. If the parents are high-income parents, this may not make a big difference. If the parents are lower-income parents, then the child's income might end up being taxed at a higher rate in the long run.

Benz: The last item I want to cover with you, Tim, relates to Coverdell accounts, education savings accounts, and 529 plans. It sounds like 529 plans will be the go-to vehicle for people saving for school in general. Let's talk about what's going on there.

Steffen: Coverdells have been around longer than 529s, or it feels like it anyway. The one real advantage they always had over 529s is that they were the only way to save in a tax-deferred basis for K-12 expenses. Other than that, 529s had every other advantage over a Coverdell. That's been tilted even more now in favor of 529s, because now, beginning next year, you can take up to $10,000 out of a 529 to use for K-12 expenses.

As a result of that, while Coverdells aren't officially being closed down or shut off, I think over time, that's certainly going to happen. One of the proposals we saw early this year would have eliminated future contributions to Coverdells. That didn't happen, so you can still contribute, but quite frankly, I don't see any reason why anybody would anymore; 529s really are the dominant education savings vehicle going forward.

Benz: It seems like in all of these cases, Tim, people would probably want to get some additional tax guidance before going forward. We thank you so much for providing these tips, really helpful stuff. Thank you for being here.

Steffen: Happy to do it, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.