Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With the new tax laws fewer taxpayers are likely to benefit from itemizing their deductions than in the past. Joining me to discuss the implications of this is Tim Steffen. He is director of Advanced Planning for Baird Private Wealth Management.
Tim, thank you so much for being here.
Tim Steffen: Thanks, Christine.
Benz: There's a lot changing in the tax code beginning in 2018, but I want to focus specifically on deductions today. Let's talk about the key changes in terms of deductions, standard versus itemized and so forth.
Steffen: Some big changes in the way taxpayers will go about calculating taxable income this year. You've got the standard deduction, which is the flat amount that all taxpayers can use to reduce income. That amount has essentially doubled for all taxpayers, not quite but pretty close. You've also repealed the personal exemptions, but that's a separate issue.
The other side and the deduction side is the changes to the itemized deduction. For those who don't take the standard, you've got itemized, which is this group of various expenses you can take deductions for, things like, income taxes, and mortgage interest, and property taxes, and charitable contributions, all of those things. Some fairly big changes on that side.
On the tax side, state income and property taxes in 2017, you could deduct everything you paid; in 2018, you are limited to $10,000.
Benz: Which is a big deal for people in high-tax states, right, or where there's high property taxes and sometimes those are the same states?
Steffen: Or people who own multiple pieces of property, or maybe had two or three homes or other pieces of real estate where they were deducting the taxes, those deductions are all going to be limited now to that $10,000 cap.
The other big one that was repealed is this whole category of miscellaneous expenses. Things like tax preparation fees and investment expenses and unreimbursed business expenses and union dues and all of those types of things. Those were all deductible under this category of miscellaneous deductions. Those are all gone now, or at least, temporarily. All these changes are all set to be repealed after 2025. We will see what happens when we get there. But for now, so that whole category of expenses is gone.
Other changes, they expanded charitable contribution slightly; mortgage interest, some changes there, but more for new homebuyers. Existing mortgages will generally be the same as they were before other than home equity loans. But all in all, it's fair to say that most taxpayers will have fewer itemized deductions in 2018 than they did in 2017, all things being equal.
Benz: Let's talk about the itemized deductions that you were just talking about. Accountants like you sometimes call those below-the-line deductions and those stand in contrast to above-the-line deductions. Let's talk about the differentiator between the two.
Steffen: You've got these two different groups of expenses, what we call, above-the-line and below-the-line. First of all, let's define the line. The line is what we call adjusted gross income. If you can visualize your tax returns, the last number on the front page of your 1040 or the first number on Page 2, that's the income number after certain adjustments that you are able to claim.
There is a certain group of expenses that are called the above-the-line deductions that all taxpayers can claim regardless of whether you itemize or take the standard deduction later on. These are going to be things like IRA contributions, SEP contributions, health savings account contributions, alimony to the extent that you are still claiming deduction for alimony and a number of other expenses that fall in that category. Those are all the above-the-line ones that reduce gross income down to adjusted gross income. And again, everybody gets those deductions if you have one.
Benz: We are not seeing major changes to those, correct?
Steffen: No real changes to those, other than maybe the alimony one beginning next year. But otherwise, yeah, no real changes there.
All the other things we talked about, the itemized deductions, those are all considered below-the-line, and you take those either the itemized or the standard deduction.
Benz: oome people might hear that and think, OK, I can stop saving my receipts if I am not going to be worrying about itemizing. What do you think? How should people approach that question of whether they will be an itemizer in a given year or claim the standard deduction?
Steffen: IRA statistics in the past have shown that roughly 70% of taxpayers take the standard deduction, and that's been pretty consistent for the last several years. That's the 2016 number as well. The estimates are now that when you combine the larger standard deduction with fewer itemized deductions, up to as many as 90% of taxpayers will now take the standard deduction, which means, fewer people having to go through the effort of collecting all those receipts and everything. They will be using the standard as opposed to the itemized. But it also means that they may look at some of those expenses they've got and say, well, I'm not taking a benefit for them anymore. They are maybe not as valuable to them anymore. They have got to rethink maybe some of the expenses that they have been paying and what the tax treatment is of those.
Benz: One strategy you have written about is to think about bunching those itemized deductions to try to gather them into a single year. I think people might hear that and say, well, things like medical expenses, don't have a lot of control over them. But how can people approach that question and potentially itemize in some years?
Steffen: With the larger standard deduction, let's say, you've got somebody who had maybe $20,000 of itemized deductions in 2017. They would take a deduction with those expenses. In this year, that married couple, the standard deduction is $24,000. All those itemized deductions they were claiming, they are not going to get a benefit for it anymore. They are going to get the flat $24,000. Does that mean they would stop paying some of those expenses? Well, you know, you can't really stop paying your state income and property taxes. States won't like that. You can't stop paying the interest on your mortgage because the bank isn't going to like that. Things like medical expenses you said, you can't really not pay those. If you are sick, you got to pay them.
But charitable contributions is the big one that I think people have the most flexibility with and are maybe the most likely to rethink if they know they are not going to get a tax deduction for it or if the deduction is maybe not what it once was. For those who are going to find themselves falling from itemizing to standard, they may look at those charitable expenses and say, I don't get a tax benefit for those anymore, maybe I don't need to make those anymore. If they were doing it for strictly tax purposes, that reason is gone now for some taxpayers.
Benz: The strategy though would be to think about if you are charitably inclined and you want to make a significant contribution to a charity or a group of charities, to maybe hold on to those for a single year and get the bang for your buck in terms of itemized deductions. How would that work?
Steffen: Let's say, you make a little bit of charitable contributions every year, but just enough that you can't quite get over that standard deduction, that $24,000. Instead of making all your charitable contributions every year like you normally do, maybe you hold off on making any donations here in 2018, defer them all to 2019. In 2018, your itemized deductions would fall but you are still below the standard deduction, so you continue to claim that. In 2019, however, by doubling up your charitable gifts now you've gotten yourself above the standard deduction and you actually get to itemize, you get a tax benefit for those gifts. Over the two-year period you haven't paid any more in expenses or any more charitable gifts than you otherwise would have, but in one year you took standard deduction, the next year you itemized. That's the concept of bunching. Bunching is a technique. It's been around forever. We've always talked about this. But with these changes in rules, it's really come into the forefront again and it's really a planning opportunity people are talking about now.
Benz: Let's talk about how a donor-advised fund can fit in with this bunching strategy for charitable.
Steffen: Let's say you are someone who is going to double up on your charitable contributions, maybe you defer this year's into next year. The charities don't necessarily like that because they lose that year of revenue with it. They go a year without getting any gifts. You may say, well, I don't want to harm the charity. Instead of going doubling up next year I will double up this year and do all my gifting this year. But then you say, well, maybe I don't necessarily know who I want to give all the money to yet or I don't want to give it all to the charity this year, I still want them to have some this year and next year.
One of the techniques that really plays into this whole bunching thing is the donor-advised fund. And donor-advised funds have been around for a while now. They have been a great planning tool for a long time. But the way those work is you put money into the account, think of it like a miniature private foundation. You fund the account today, you get the tax benefit today. The money is in the account. You can invest it, you can earn more money. And over time, you give it out to charity as you see fit. You can't reclaim the money. It's a completed gift. You get the tax deduction for it, but you can decide who to give the money to charities to over time.
In this bunching technique then you would double up on your charitable contributions now, in 2018, and then you use that, say, maybe you give your 2018 and 2019 contributions all into the fund now, then over the next two years you write checks out of that fund to the charities. From the charity's standpoint, they don't know any difference. They are getting the same amount, but you as a taxpayer have gotten the tax benefit upfront and you have been able to itemize. In the next year, you won't have any charitable gifts, you would go back under and take the standard deduction.
That's where the bunching and the donor-advised fund really kind of play into each other.
Benz: Another neat thing about donor-advised funds is that you can actually put securities into them, right? If you have something that's maybe illiquid, some sort of company ownership, you can put that in the donor-advised fund. The entity managing it knows how to deal with that.
Steffen: Exactly, yes. Donor-advised, because again, they are kind of like a private foundation. You work with another entity to manage it and they will tell you whatever they are willing to accept and most of them are willing to accept not only cash but stock shares and mutual fund shares and some will even take more illiquid property like artwork or vehicles or something like that would be fine, some of the more sophisticated ones. You can give those appreciated assets to the fund just like you would if you were giving a right to the charity. But now it's inside the donor-advised fund. That fund may end up selling that asset or they will work with you to decide how you want to manage that. But you can get the same tax benefit from giving appreciated stock to a donor-advised fund as you would if you give a right to the charity itself.
Benz: Whole new world here in terms of the tax regime. Tim, thank you so much for being here to discuss some of these strategies.
Steffen: Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.