Our Christmas “gift” from the Republican Congress and administration came in the form of a rushed, complex, far-reaching tax overhaul: The Tax Cuts and Jobs Act. There were numerous articles describing tax-savings moves to make before Dec. 31, 2017, but it’s now 2018. Many analysts provided illustrations of how the new rules will increase a typical individual’s tax liability, while others were certain that the law will decrease the average taxpayer’s tax hit.
Speculation about how the law will affect Americans in general has little to do with ramifications to any particular taxpayer. With that in mind, I will begin with a brief overview of the new provisions, followed by recommendations on what to do.
The law slashes corporate tax rates and cuts individual tax rates—especially for high-income taxpayers. The corporate reductions are permanent, while the individual tax cuts expire after 2025. Over the next decade, these provisions are expected to add about $1.5 trillion to the U.S. deficit.
Reductions for Individuals
- Tax rates lowered to a maximum of 37% from a maximum of 39.6%. Material reductions don’t occur until income levels are over $75,000 for singles and $150,000 for married couples.
- The standard deduction doubles to $12,000 for singles and $24,000 for married couples. This means that fewer people will itemize deductions.
- Deduction of medical expenses over 7.5% of adjusted gross income now allowed, down from 10%. This is not a deduction you want to qualify to take!
- Exemptions from the Alternative Minimum Tax increased. Fewer high-income people will be subject to the AMT, and if subject to the AMT, they will pay less.
- Child credits double to $2,000, the refundable portion increases to $1,400, and a $500 credit for nonchild dependents is allowed. This is only allowed for dependents with Social Security numbers. According to the Center on Budget and Policy Priorities, 10 million children from low-income families will receive only about $75 of additional benefits.
- The estate-tax exemption doubles to almost $11 million per person. At the current exemption amount, only about 0.2% of Americans who die owe any estate tax. Doubling the exemption amount would bring this number down greatly, benefiting only ultra-high-net-worth families.
Increases for Individuals
- Personal exemptions eliminated. At the current $4,050 each, this elimination essentially offsets any benefit from the standard deduction increase.
- The mortgage interest deduction reduced for new purchases of main and second homes to a maximum principal of $750,000, and deductions for home-equity interest eliminated. This could depress residential housing prices for high-price homes.
- Miscellaneous itemized deductions, including tax preparation fees, investment-management fees, employee business expenses, and professional dues eliminated. This does not have an impact on those subject to the AMT. It hits primarily working-class individuals and families.
- Deductions for state, local, and property taxes reduced to $10,000 combined maximum. This provision, combined with the higher standard deduction, means fewer people will itemize. It is another provision that could depress residential housing prices—especially in high-tax states.
- Moving expense deductions, except for military, eliminated. This places a financial burden on workers who need to move for employment.
- Casualty loss deductions except for presidentially declared disasters eliminated. This places a financial burden on anyone incurring a casualty loss such as a home fire or robbery. It also means that insurance is more important than ever.
The law also eliminates the health insurance mandate (penalty for not having medical insurance) beginning in 2019. If this provision isn’t reversed before its effective date, it will lead to millions of people opting out of health insurance, which, in turn, can raise premiums for those opting for coverage.
- The top corporate rate lowered to 21% and eliminates the corporate AMT. This is a huge reduction.
- Tax reduction for “pass-through” entities (sole proprietorships, partnerships, limited liability companies, and S corporations) allowed, not including personal-service businesses (unless taxable income is less than $157,500 for singles and $315,000 for married couples). These provisions are complicated and convoluted. It will take time to determine how best to structure businesses that rely on owners’ “sweat equity.”
- Entertainment expense deductions eliminated. This will be a huge blow to sports leagues whose season ticket holders are primarily businesses, as well as to other entertainment/ cultural organizations.
- Research costs (including software development) can no longer be expensed; they must be amortized over five years. This does not apply to oil and gas companies. This deals a big blow to business innovation—especially small businesses.
- The orphan drug credit reduced. This lowers the incentive to develop cures or treatments for rare diseases.
What Should You Do?
We are all subject to a new world of tax laws, thanks to the new law. We can’t change the past, so what strategies and moves should we consider? Here are my recommendations:
Watch Your Withholding
New withholding tables will likely reflect lower tax rates under the new law. While taxpayers might feel good about getting a larger check each payday, the tables might not represent their tax picture. In other words, taxpayers should be wary of fast money in their pockets. They might end up owing more come April 2019.
Determine Whether You Will Itemize or Claim the Standard Deduction
Many traditional itemized deductions are no longer allowed, and the standard deduction has been doubled. What this means is that many more taxpayers will be claiming the standard deduction—even if they itemized in the past. As of 2018, allowable itemized deductions will be the total of:
- Medical expenses more than 7.5% of adjusted gross income.
- Home mortgage interest on principal of up to $1 million for prelaw homes or $750,000 for newly acquired loans.
- Charitable contributions.
- Maximum $10,000 of state, local, and property taxes combined.
For example, let’s compare a married couple’s allowable itemized deductions for 2017 versus 2018.
Say the couple in 2017 could deduct:
$12,000 in property taxes, $9,000 in state taxes, $8,000 mortgage interest, $4,000 home equity interest, $3,000 charitable contributions, $1,000 tax prep, and $10,000 for investment management minus 2% of adjusted gross income.
The deductions for the same couple in 2018 would be: $10,000 total property and state taxes, $8,000 mortgage interest, and $3,000 charitable contributions.
Assuming they had an adjusted gross income of $150,000, this couple’s 2017 itemized deductions would have totaled $44,000. The same expenses would result in allowable itemized deductions of only $21,000 in 2018. Without deducting home equity interest, miscellaneous itemized deductions and state/local/property taxes above $10,000, this couple will now be forced to claim the standard deduction of $24,000.
It is important to know if clients will be itemizing or claiming the standard deduction because this can have an impact on planning.
Consider Bunching Deductions
Just because taxpayers claim the standard deduction in one year doesn’t mean they can’t qualify to itemize in another year. Remember that if they claim the standard deduction, they will get no tax benefit from paying state/ local/property taxes, mortgage interest, charitable deductions, or medical expenses more than 7.5% of AGI.
How can they get a benefit? Try bunching deductions every other year. In the above example, let’s say that the couple makes their Jan. 1 mortgage payment in December and prepays their 2019 charitable commitment by the end of 2018. Additionally, let’s assume that the couple pays an orthodontist bill by the end of 2018, leaving $2,000 of medical expenses more than 7.5% of AGI. Based on this, the couple’s 2018 total itemized deductions will be $26,600—greater than the $24,000 standard deduction.
Consider a Donor-Advised Fund
A donor-advised fund can provide further opportunity to bunch charitable deductions without immediately distributing funds to specific charities. It’s like a “charitable IRA.” Investors get a tax deduction as soon as they contribute to the fund. The fund invests the money until they decide to make grants to the charities of their choice, and they don’t pay taxes on growth while the funds are invested. Also, investors don’t have to contribute cash—they may get greater tax benefits by contributing appreciated securities. They will get a deduction for the full value of the shares—and they won’t pay tax on the gain. Because they receive a charitable deduction at the time they contribute to their fund, if they establish and contribute to the fund before year-end, they will receive a tax deduction in 2018—no matter when they designate grants in the future.
Pay Attention to Other Tax-Saving Strategies
Be sure to remember other tax-saving strategies, as applicable. These can include:
- IRA, SEP, or other retirement-plan contributions, and Roth conversion.
- Self-employed health insurance and health savings accounts.
- 529 plans.
- Tax-advantaged portfolio management, such as tax-loss harvesting, tax-lot accounting, and location optimization.
- Retirement withdrawal strategies. Although much has changed under the tax law, many of the “tried and true” planning strategies can still prove beneficial.
The new tax rules will have a major impact on taxpayers as well as the U.S. economy. How they will affect you and your clients depends on your specific circumstances.
This article originally appeared in the February/March 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.