Peak Alert: GOP Tax Bill Review & Strategies
The Tax C
ut and Jobs Act Review and Strategies
Shortly after the GOP tax bill passed in December of 2017, formally known as the Tax Cut and Jobs Act (TCJA), we commented on what we believed to be the most pressing components potentially impacting Peak clients. It is time to revisit the Act to refine our original thoughts and offer more specific guidelines on navigating the new paradigm.
The bill represents the first major overhaul in our nation’s tax laws in over 30 years. As we see it, the most significant changes are as follows:
For many clients in states that levy income taxes, like Massachusetts, New York, Connecticut, and California, the most impactful provision relates to limitations on the SALT (state and local taxes) deduction, which is now capped at $10,000. Most working folks in these “high tax” states had deductions that exceeded $10,000 in these categories, sometimes by a large amount. Taken alone, this change in the tax code means lower deductions and increased taxes.
Potentially offsetting the cap in SALT deductions, tax brackets were lowered across the board and the standard deduction was nearly doubled to $12,000 for single filers and $24,000 for married couples filing jointly. For those aged 65 or older, the standard deduction has been increased to $13,300 for singles and $25,600 for married couples. These higher standard deductions are somewhat countered with the elimination of the $4,050 exemption for each individual and dependent. For taxpayers who traditionally do not itemize, the higher standard deductions coupled with the lower brackets could prove to be financially beneficial.
Some deductions have been terminated altogether. All miscellaneous deductions subject to the 2% adjusted gross income (AGI) threshold have been eliminated including investment management and accounting fees, job related expenses, hobby expenses, job related moving costs, and unreimbursed employee business expenses. Theft losses have also been done away with as have casualty losses (under most circumstances). The deduction for alimony payments has also been jettisoned and alimony received will no longer be taxed as income for decrees promulgated after December 31, 2018. The tax treatment of pre-2019 decreed alimony payments will continue unchanged unless the existing divorce agreement is specifically modified to reference the TCJA.
The mortgage interest deduction has also been limited. Before the tax changes, mortgage interest from a loan of up to $1 million to purchase or improve a primary or secondary residence was deductible. That amount has been lowered to $750,000 for a loan acquired after December 16, 2017. Now, if your home was under binding contract by December 16, 2017 and closed before April 1, 2018, the old law continues to apply. Mortgages which are re-financed after but originated before the December cutoff also are grandfathered. Importantly, home equity interest on debt used to pay for something other than home related expenses, such as buying a car, paying college costs, or paying down credit card debt, is no longer deductible, regardless of when the debt was acquired.
The attractiveness of 529 College Savings plans was enhanced considerably while trusts for minors look less attractive. Besides the other great features of 529s (potential deductions, tax free growth, and tax free withdrawals), up to $10,000 annually can be used for elementary and secondary education. With respect to trusts established for minors, the somewhat favorable “kiddie tax” rates have been replaced with the more punitive trust and estate tax rates.
The fanfare regarding changes to the corporate tax rate is well deserved. That levy topped out at 35% in 2017 but is now a flat rate of 21%. For smaller businesses such as sole proprietorships, S Corporations, LLCs, real estate investment trusts and others, a new 20% deduction towards business income has been created.
Medical deductions have been enhanced by lowering the AGI threshold to 7.5% (but only for 2018) and the charitable deduction has increased from 50% of AGI to 60% of AGI.
Other TCJA “features” worth mentioning:
- The exemption amounts for the Alternative Minimum Tax (AMT) have increased significantly from $70,300 for single filers and $109,400 for married filers with the phase out thresholds increasing dramatically to $500,000 and $1,000,000, respectively. It is fair to say the AMT will no longer plague a large number of taxpayers as it once did. According to the Tax Policy Center, the percentage of taxpayers subject to AMT will drop 96%, with only 200,000 filers expected to owe the AMT for 2018. While completing your taxes on a postcard will probably never be reality, this is one act of simplification we can stand behind.
- The inflation methodology used to index the tax brackets was changed with the result being that tax brackets will increase at a lower rate since they will now be tied to “Chained CPI.” It might sound attractive, but the result of this change is that personal income gains may accelerate taxpayers into higher tax brackets because Chained CPI is a more subdued measure of inflation. Put another way, in time more income will be taxed at higher rates. The change to the inflation benchmark is generally seen as having a negative impact on taxpayers and a positive impact on tax collections over time. Moreover, it serves as a stealth tax increase as the obscure changes to the formula will not be readily apparent to most taxpayers.
- The child tax credit has doubled to $2,000 for qualifying children under the age of 17. For those filing jointly married, the credit begins to phase out at $400,000 AGI. For all other filers, the phase out begins at $200,000. These AGI limits are much higher than they have been in the past, meaning more people will be able to claim the credit.
- Capital gains rates remain the same, but the 20% rate won’t be charged until higher income levels are attained.
- The federal individual mandate under The Affordable Care Act (Obamacare) was repealed.
- Most of the individual income tax cuts sunset in 2025.
There are prudent steps people can take in light of the new and sometimes complex rules. Here are a few:
For many it will be difficult to determine the exact impact of the new rates, brackets, and limitations. A good place to start is to look at Schedule A of your 2017 tax return, otherwise known as your itemized deductions. If 2018 is not much different than 2017 for you, simply cap the amount in the “Taxes You Paid” box at $10,000 and zero out the entry for “Job Expenses and Certain Miscellaneous Deductions.” If all the itemized deductions are less than the applicable standard deduction ($12,000 for singles and $24,000 for married couples or $13,300 for singles and $25,600 for married couples over age 65), you will most likely take the standard deduction. If the higher of your itemized deductions or standard deduction is much lower in 2018 than the deduction taken on your 2017 federal return, with all else being equal, chances are your taxes are going to increase (notwithstanding the lower brackets).
As such, for many itemizers, a possible reduction in the tens of thousands of dollars of what they may have itemized in 2017 is in the cards. There is no practical permanent remedy for most, but there are prudent actions you can take now.
With respect to no longer being able to deduct investment management fees, it could make sense for you to have the fee debited from a qualified accounts such as an IRA. Investment management fees are considered a non-taxable distribution from an IRA, and all things being equal, future required minimum distributions are reduced. This small change effectively claws back a portion of the lost deduction through this non-taxable distribution to pay management fees.
Also, if you are charitably inclined, contributing to a Donor Advised Fund or making a Qualified Charitable Distribution from your IRA continues to be one of the most tax efficient ways to increase your deductions or reduce your taxable income, respectively, and still support the 501(c)(3) organizations that do so much good in our communities. One way to “beat the system” is to bunch deductions in 2018 (this can work in a future year as well). For example, if you’re married and your itemized deductions add up to $20,000 but you normally give $2,000 to charity every year, you can frontload five years of contributions (i.e. $10,000) and push your itemized deductions above your standard deduction. Matching oversized charitable contributions with medical expenses is a good method you can use to cherry pick years and combine many years of future deductions into one.
The best way to reduce your federal tax liability, especially in the states most impacted by SALT, is to contribute as much as you can to your retirement plan (e.g. 401k, 403b, 457 etc.) and/or health savings account. In 2019, combined, a couple can shelter up to $50,000 (and sometimes more depending on the type of plan). In an era of potentially higher tax burdens for folks in the high tax states, deferring income into a retirement plan is a gift to yourself in the form lower taxes and a more comfortable life after your working years.
We obsess over retirement planning here at Peak. Saving more is always important to us and setting aside funds in a tax deferred account is almost always the optimum way to save. With many popular deductions being decreased or eliminated, and with the elimination of personal exemptions, retirement plan deferrals become more crucial than ever for lowering your tax burden.
Certain educational tax benefits, such as the Lifetime Learning Credit, the American Opportunity Credit, and the deduction of student loan interest continue to be applicable although income phaseouts apply, which will limit these benefits for high income individuals and families. As noted earlier, parents, grandparents, and loved ones smartly setting aside funds in 529 College Savings plans may have even greater reason to do so, as these plans now allow qualified withdrawals up to $10,000 annually per beneficiary for the cost of K-12 private schools. Clients holding Coverdale Education Savings accounts, designed exclusively for use for private pre-college schooling, should consider rolling those funds over to a 529 plan. Other accounts traditionally established to help children, known as UTMAs and UGMAs, have become substantially less attractive under the new law, as account earnings over a certain threshold are charged the same high rates levied on certain types of trusts and estates. As with the Coverdale accounts, it may be wise to move these types of trust assets to 529 plans (or spend the funds on qualified expenses) before the higher tax rates take a bite out of account earnings. Future savings for children might now be better set aside in an individual or joint account where the donor’s tax bracket applies.
At Peak, we place estate planning near the top of the list with respect to executing a sound financial plan and the higher federal estate tax limits make that task a bit easier. However, many states levy their own estate taxes with comparatively low exemptions. For example, in Massachusetts, estates valued at $1,000,000 are subject to an estate tax and that level is not indexed for inflation. However, it is important to remember that estate planning is so much more than simply reducing federal or state estate taxes. It is preparing in advance to have your family, friends, and any interests important to you taken care of by your instruction should something unexpectedly happen to you. At the very minimum, we stress that everyone should have a Will, Health Care Proxy, and Durable Power of Attorney. This includes your children who are eighteen and over, as they are no longer minors in the eyes of health institutions and government.
The positive tax provisions of the JTCA applicable to sole proprietorships, LLCs, partnerships, and S corporations (nearly 40 million taxpayers) is good news for owners of pass through businesses. This provision is fraught with complications, with certain professions such as lawyers and doctors facing income phase outs and caps on deductions. Even with the complexities, many small business, and even large ones set up the “right” way, could see significant tax benefits for years to come. Collaboration with a tax professional to explore how the new rules could positively impact your business is strongly advised.
It is important to note that the IRS is giving no leeway to taxpayers who underpay their taxes throughout 2018 even though the calculations have changed dramatically. To see if you are on track, the IRS has created a web based tool to determine whether an estimated tax payment in December might be necessary. The calculator can be accessed here – it is simple, but extremely useful: https://apps.irs.gov/app/withholdingcalculator/.
One of the hallmarks of our approach here at Peak Financial Management is to strive to control the controllable. Smart strategic steps designed to mitigate your tax obligations can positively impact your wealth the same way portfolio gains can, but unlike the investment markets, with taxes you have more control. We welcome your questions and encourage you to work with your accountant or tax preparer to make sure that you are doing all you can under this new legislation to minimize your tax burden. We always stand ready to assist you in making the right decisions, whether it be on taxes or any other important aspect of your financial life.
Regards,
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