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Investing Specialists

What You Can Learn from Your 2017 Tax Return

Despite the new tax laws, your recently completed tax documents yield valuable intelligence about your financial and investment life.

New tax rates. An increase in the standard deduction. The repeal of the personal exemption. A cap on the deductibility of state and local taxes, along with property taxes. 

The Tax Cuts and Jobs Act of 2017, which was signed into law in last year's waning days, ushers in significant changes to the individual income tax framework.

All of those alterations mean your 2018 tax return could look a lot different from the one you've just filed (or are getting ready to file--get on the stick!). One of the most significant changes will be that many fewer taxpayers will benefit from itemized deductions going forward, as the new, higher standard deduction amount ($12,000 for single filers and $24,000 for married couples filing jointly) is apt to be higher than their itemized deductions in most years.

Yet despite these changes, your previous year's tax return offers valuable intelligence about your investment and financial life. Rather than focusing just on the bottom line of your tax return--what you owe or what you're getting back--it pays to take a closer look at what's actually on those forms. Here are some of the key items to focus on.

Line 6 of Your 1040: Exemptions
The new tax laws repeal personal exemptions, which in the past effectively reduced income for each person on a tax return--the taxpayer and his or her dependents. This change partially offsets the benefits derived from the increase in the standard deduction, though families with children younger than 17 will benefit from a higher child tax credit.

Line 8 of Your 1040: Interest Income
You can see the raw dollar amounts of your interest income on line 8 of your 1040 form. Line 8a shows taxable interest income, or "interest," and line 8b shows tax-exempt interest income, generally from municipal bonds. If you have a high level of taxable interest income, make sure that you're paying attention to asset location and have assessed whether taxable bonds and money markets, rather than municipals, are truly the better bet for your taxable savings, once the tax effects are factored in. Now that yields cash and bond yields are finally trending upward, the negative tax effects of improper asset location will be more meaningful.

Part I of Schedule B provides specific details on how much interest income various securities have delivered. If you have paltry levels of income from a smattering of cash accounts, see if you can consolidate them into a single, higher-yielding option. (One piece of good news is that cash yields have recently popped up comfortably above 1.5%.) If you didn't receive a 1099 from financial institutions where you know you hold cash, such as your bank, don't be alarmed; it's possible that your interest was less than $10, so the institution doesn't need to send you a 1099. You're technically still required to report that interest, however; you should be able to find the amount online.

Line 9 of Your 1040: Dividend Income
Line 9a shows the total amount of ordinary dividends you received last year; those that count as qualified--meaning that they're subject to the more favorable qualified dividend tax treatment--are on line 9b. As with taxable interest above, take a hard look at any investments, such as REITs, that are paying nonqualified dividends that you're being taxed on; those investments are better housed in a tax-sheltered account such as an IRA, if possible. Even if you don't own a dedicated real estate fund, you may end up with substantial REIT investments if you have a large position in a value-oriented equity fund or equity-income fund. In a similar vein, some of your dividend-focused mutual funds may hold investment types like convertibles and preferred stocks to boost their income; income from those securities doesn't typically qualify for the favorable qualified-dividend treatment. Part II of Schedule B depicts dividends received from all sources last year.

Line 11 of Your 1040: Alimony Received
Note that this is one part of tax code that is changing starting with 2019. For divorce agreements finalized on or following Jan. 1, 2019, the payer of alimony cannot deduct those payments, whereas the alimony does not count as taxable income for the payee. This reverses the current tax treatment of alimony. Karen Wallace discussed that change here, as well as the implications for both recipients and payees.

Line 13 of Your 1040: Capital Gain (or Loss)
Many investors may have realized sizable capital gains in recent years--whether they sold appreciated winners from a taxable account or one or more of their mutual funds realized gains and made a distribution. If one of your fund holdings made a big capital gains distribution last year, have you considered whether that fund might be a better fit in a tax-sheltered account? Investors in actively managed funds have seen the biggest capital gains distributions in recent years, underscoring the virtues of opting for exchange-traded, broad-market traditional index, or tax-managed funds for equity exposure instead. Because you receive a step-up in your cost basis when your fund makes a distribution and you reinvest it, switching to a more tax-efficient portfolio may cost you less in taxes than you might think, as discussed here

Note that going forward, just like in years past, there remains a 0% tax on long-term capital gains for certain taxpayers--in 2018, that rate will apply to single filers with taxable incomes of up to $38,600 and married couples filing jointly with taxable incomes of up to $77,200. That leaves open the door for tax-gain harvesting--pre-emptively selling appreciated winners with an eye to washing out the gain without any tax costs. Even if the investor would like to maintain exposure to that same stock or fund, he or she can sell at no tax cost, re-buy immediately thereafter, and increase the cost basis in the security. If the security appreciates and the investor is no longer in the 0% capital gains bracket in the future, the taxes due upon sale will be lower than would otherwise be the case.

Line 25 of Your 1040: Health Savings Account Deduction
Have you evaluated whether a health savings account, used in conjunction with a high-deductible healthcare plan, is a good fit for you? For those who are relatively healthy and have cash on hand to cover out-of-pocket expenses that might arise until they hit the maximum for the year, HSAs can serve as supplemental savings vehicles. They offer pretax contributions, tax-free compounding, and tax-free withdrawals for qualified health-care expenses. The money in your HSA can be invested and (not to be confused with a flexible spending arrangement) will roll over from one year to the next. Yes, the HSA/high-deductible healthcare plan combination can be a bit more of a hassle than being covered by a traditional healthcare plan, but healthy higher-income workers, in particular, stand to benefit from having an HSA. Its triple tax benefit is unmatched relative to any other tax-sheltered savings vehicle.

Line 31a Alimony Paid
As noted above, the tax treatment of alimony is reversing for divorces finalized on Jan. 1, 2019, or after: Alimony will not be deductible by the payer, but the recipient will not owe taxes on it.

Line 32 of Your 1040: IRA Deduction
If you made a Roth IRA contribution for 2017, you won't see anything on this line, as you can't deduct a Roth contribution. But have you given much thought to the Roth versus traditional IRA decision? Many investors reflexively assume a Roth IRA is the way to go. But if you are closing in on retirement, haven't saved much, and can deduct your contribution, funding a traditional IRA may be a better bet than putting money into a Roth. If you're not contributing to a company retirement plan, you can deduct your traditional IRA contribution regardless of income level. For 2018, single filers earning less than $73,000 who are covered by a company retirement plan can make at least a partially deductible contribution to a traditional IRA for the 2018 tax year. Married couples filing jointly who are eligible to contribute to a company retirement plan can make at least a partially deductible IRA contribution if they earn less than $121,000.

Even if you can't deduct your IRA contribution or make a Roth contribution because you earn too much, the backdoor Roth IRA is still an option. High-income earners can get money into the Roth column by funding a traditional nondeductible IRA (there are no income limits on contributions) and converting to Roth a while later (no income limits on conversions, either). Just be sure you don't have a lot of traditional IRA assets that have never been taxed, and remember to file Form 8606, which documents your nondeductible IRA contribution. This article goes into greater detail on backdoor Roth IRA contributions.

Line 40 of Your 1040: Itemized Deductions or Your Standard Deduction
Among the most significant implications of the new tax laws for individuals are the changes on the deduction front. Note that IRA contributions--discussed above--reconsidered an "above-the-line" deduction; they're deductible, assuming your income falls below the thresholds, regardless of whether you itemize or not.

But below-the-line deductions, which are deducted once you've calculated your adjusted gross income, are changing significantly. Not only is the standard deduction going higher, but there are also new restrictions affecting the deductibility of certain items. For example, the deduction for state and local taxes, as well as property taxes, is now capped at $10,000. In addition, the new laws limit interest deductibility to mortgages of $750,000 or less. (For properties purchased prior to Dec. 15, 2017, interest on mortgages of up to $1 million is tax-deductible.) In addition, home equity loan interest will only be deductible if the loan is used to finance home improvements, not new car purchases or basic home maintenance.

The idea of not having to itemize deductions might seems incredibly freeing. It was no fun, after all, to track down all of those healthcare and charitable contribution receipts during tax season. But don't write off itemizing altogether. Some taxpayers may find that it's worthwhile to itemize in certain years and claim the standard deduction in most others. For example, if a taxpayer incurs heavy medical expenses and makes high charitable contributions in a given year, those itemized amounts may be greater than the standard deduction. So save your receipts--or at least make sure you have a good system for retrieving them if you need to--before giving up on itemization altogether.

Line 50 of Your 1040: Retirement Savings Contribution Credit
Single filers with incomes of up to $31,500 in 2018 and married couples filing jointly with incomes under $63,000 in 2015 can take advantage of a credit for their contributions to IRAs and company retirement plans. The lower the income, the larger the credit--up to $1,000 for individuals and $2,000 for married couples. A credit, in contrast with a deduction, is especially valuable in that the credit amount is deducted directly from your bottom-line tax bill. Note that this credit is in addition to--not instead of--allowable deductions for contributions to traditional IRAs and 401(k)s. Form 8880, which you'll need to fill out and attach to your 1040 form (not 1040EZ) to claim the credit, provides more details on how to calculate it.

Line 52 of Your 1040: Child Tax Credit
Prior to 2018, this credit was worth $1,000 per qualifying child and was refundable to taxpayers with at least $3,000 in earned income. Starting this year, the credit is $2,000 per qualifying child under 17 and is refundable up to $1,400 for taxpayers with earned income of more than $2,500.

Lines 1-4 of Schedule A (Itemized Deductions): Deductions for Medical and Dental Expenses
As noted above, in the future fewer taxpayers are apt to use Schedule A, where they document their itemized expenses, as the standard deduction will be higher in many cases. However, the new tax laws are more generous with respect to certain itemized amounts. For the 2017 and 2018 tax years, medical and dental expenses will be deductible to the extent that they exceed 7.5% of adjusted gross income.

Lines 5-9 of Schedule A (Itemized Deductions): Taxes You Paid
One of the biggest changes to itemized deductions, taking effect in 2018, is that the deductibility of state and local income and property taxes will be capped at $10,000 in total. That cap is one of the major reasons that many fewer taxpayers will benefit from itemizing their deductions versus claiming the standard deduction. Unfortunately, there's not much you can do about it, save for contemplating a move from a high-tax state to a lower-tax one (along with all of the lifestyle trade-offs that that entails).

Lines 10-15 of Schedule A (Itemized Deductions): Interest You Paid
In another blow to homeowners in expensive parts of the country, the new tax laws put in place more stringent guidelines around the deductibility of home mortgage interest and home equity loan interest. As noted above, the tax laws limit interest deductibility to mortgages of $750,000 or less. (For properties purchased prior to Dec. 15, 2017, interest on mortgages of up to $1 million is tax-deductible.) In addition, home equity loan interest will only be deductible if the loan is used to finance home improvements (like home additions), not new car purchases or home maintenance.

The fact that many fewer taxpayers will benefit from itemization--along with the more stringent rules related to deductibility of home-related debt--makes it hard to consider mortgage debt "good debt" and embellishes the case for mortgage-debt paydown. That's especially true for older homeowners who plan to stay in their homes, are late in the life of their mortgages (and hence most of their payments go toward principal), and would like to reduce their amount of debt coming into retirement.

Lines 16-19 of Schedule A (Itemized Deductions): Gifts to Charity
As with medical expenses, here's another area where taxpayers would be wise to think strategically, making large contributions in single years when they itemize. (And it's obviously easier to exert control over the timing of charitable contributions than it is over the timing of healthcare expenses.) Donor-advised funds can make a lot of sense in this context, allowing a taxpayer to obtain a deduction for the year in which the funds are contributed to the donor-advised fund but then distributing the money deliberately over a period of years.

In addition, the fact that many taxpayers will be claiming a standard deduction rather than itemizing underscores the case for the qualified charitable distribution, the merits of which are unaffected by the new tax laws. With a QCD, an RMD-subject investor over 70 1/2 would steer a portion of his or her RMD from an IRA, up to $100,000, to the charit(ies) of choice, thereby reducing taxable income. Retirees who have been writing checks to charity and deducting their charitable contributions might consider, to the extent that it's practical, the QCD instead.

Lines 20 of Schedule A (Itemized Deductions): Casualty and Theft Losses
Unless you incur losses in a federally declared disaster, this deduction is not available for taxpayers from 2018 through 2025.

Lines 21-27 of Schedule A (Itemized Deductions): Job Expenses and Certain Miscellaneous Deductions
From 2018 through 2025, miscellaneous itemized outlays that were deductible in the past, to the extent that they exceeded 2% of adjusted gross income, will not be allowable, including unreimbursed employee expenses and financial advisor fees. Financial planning guru Michael Kitces does a deeper dive into the tax treatment of financial advisor fees in this posting on his Nerd's Eye View blog.

Form 6251
This is the form you use to determine whether you owe the Alternative Minimum Tax and if so, how much. Taxpayers are required to calculate their taxes using the standard and AMT methods, then pay whichever tax is higher. Thanks to the new tax laws, including increased AMT exemption amounts and higher income thresholds for those exemptions, many fewer taxpayers are expected to be subject to the AMT than in the past. If you've been subject to the AMT before, check with your tax advisor for his or her best estimate of whether you're likely to be in the future.

W-2s and 1099s
This article takes a closer look at what you can learn from last year's W-2 and 1099 forms, including whether you’re taking full advantage of the retirement savings opportunities available to you and whether you're practicing savvy tax management with your portfolio.