The new tax law is a mixed bag for many, but it does contain some hidden gems. Though the tax filing season for 2017 is winding up, it’s important to know how the reforms may affect your bill next year.
This article is not meant to be an exhaustive list of all the changes outlined in the law signed in December 2017 (after all, it clocks in at more than 1,000 pages). Instead, we’re highlighting the changes we observed to be most relevant to many of our clients, and how they may affect the planning process.1 Let’s start with the basics:
What Changes Should You Know About?
The new tax law (also known as the “Tax Cuts and Jobs Act”) affects 2018 income taxes. It significantly reduces tax rates for most businesses, and across all brackets for individuals, reducing the top rate from 39.6% to 37%. The law expands the individual tax brackets themselves and almost doubles the standard deduction to $24,000 for married taxpayers filing jointly, with similar increases for other filers. These moves mean that many taxpayers will owe much less in federal tax next filing season.
However, the law brings another change that works in the opposite direction — it eliminates personal exemptions and also eliminates or reduces many of the itemized deductions that numerous Americans enjoy on Schedule A of their Form 1040. Perhaps the most significant change for millions of Americans is the new limit to the deduction for state and local income and property taxes to $10,000 in total.
This means significantly fewer taxpayers will benefit from itemizing their deductions, especially those residing in states with meaningful income tax rates like California, Minnesota and Wisconsin, to name a few. Taxpayers in these states and many others may find that this change alone will keep them from itemizing their deductions; instead, they will use the higher standard deduction. Many analysts are estimating that more than 90% of taxpayers will now claim the standard deduction.
In addition, charitable giving is an area that potentially could take a “hit” under the new law. While charitable contributions are technically still deductible under the Tax Cuts and Jobs Act, many individuals will not receive a tax benefit from their giving efforts, unless they are one of the few who will have enough total deductions to itemize. While there are many reasons that people give to causes important to them, the tax benefits are often a factor. Those claiming the standard deduction do not receive such tax benefits from their generosity.
Some people may find that grouping their charitable giving into an “every-other-year” strategy (or contributing significant amounts to a donor-advised fund upfront) will allow them to have high-enough deductions to itemize in certain years, while using the standard deduction in other years. Of course, taxpayers will have to decide whether it is worth the time and effort — and what “uneven gifting” means to the organizations they care about — to consider such a strategy. Lastly, for those who donate large amounts to charity in relation to their adjusted gross income (AGI), one benefit under the new law is that the AGI deductibility limitation has increased from 50% to 60% of AGI.
To the relief of homeowners everywhere, mortgage loan interest is also still deductible in most cases — but again, only those who itemize deductions will benefit. Plus, taxpayers who are purchasing expensive homes may be limited by the fact that only the first $750,000 of acquisition debt will now generate tax-deductible interest. Also, interest deductibility for home equity loans is eliminated or significantly restricted under the new law, which will hurt some families.
Some changes will also affect families using 529 college savings plans to fund their children’s higher education: Withdrawals of up to $10,000 annually from 529 plans to fund private elementary- or secondary-school expenses now count as qualified (tax-free) distributions, in addition to post-secondary school (college) expenses.
What Changes Affect Businesses?
In a future article, we’ll explore this aspect of the new tax law further — but overall, business owners will likely be pleased. The new tax law expands, or “makes permanent” (if there is such a thing in tax law) several write-offs and deductions which can significantly reduce taxable income, such as expanded bonus depreciation opportunities. The law expands Section 179 deductions significantly. Another well-publicized aspect of the rule affects C corporations, which will now pay a flat rate of 21% — a large reduction.
And then there’s the big one: The Section 199A deduction for certain “pass-through entities” (including sole proprietorships, partnerships, S corporations and limited liability corporations), particularly those that are not “personal service” businesses. This change results in a deduction of up to 20% of qualified income from the taxable income of such entities. The deduction is somewhat complex (and the IRS needs to provide further clarification and guidance around it) but can be significant for those businesses that qualify. In fact, the change may lead many businesses to reconsider their form of entity — much more to come on that topic.
What About Estate Tax Reform?
For those with large estates, the federal estate tax exemption has been doubled from $5 million to $10 million per person in 2011 dollars (inflation-indexed, so the exemption is actually $11.2 million per person in 2018). This change means that a very small percentage of estates will face a federal estate tax going forward. However, a few states (including Minnesota) still have a state-level estate tax at a significantly-lower threshold. Strategic planning is still necessary for families everywhere!
What Hasn’t Changed?
There are many aspects of the code that won’t be affected by the new tax law — such as a favorable tax rate for long-term capital gains, which is 15% of the gain amount for most taxpayers (though others still pay a 0% or 20% rate). To the chagrin of many, the alternative minimum tax (AMT) was not repealed under the new law.
Roth IRA rules are largely unchanged — Roth conversions are still allowed for all taxpayers, and contributions are still allowed for many. However, unwinding a Roth conversion through a “recharacterization” in the subsequent year has been repealed under the law. Again, solid long-term financial and tax planning can lead to smart tactical opportunities for plenty of families.
What (if Anything) Should You Do About the Tax Law Changes?
Importantly, most of the changes for individual taxpayers are not “permanent” in the law; they “sunset” after 2025, meaning they may be in effect for only a few years, dependent upon future tax laws enacted by Congress. Thus, longer-term planning will be more important than ever and somewhat complicated by this future uncertainty. It could very well be that making some tactical tax planning adjustments now and during the next few years will make sense, while your long-term tax, financial and investment planning strategies may not change dramatically.
As is the case with most matters, it depends on your unique circumstances. Be sure to meet with your financial and tax advisory teams to discuss how the changes may affect you moving forward, and how you can be prudently positioned for what is offered in the “mixed bag” of this new law.