Tax Reform: A Practical Guide

I am writing this blog Friday, December 22, the last working day for me before Christmas. I’ve been so busy, I haven’t had a chance to write one of these newsletters in a long time, but I felt it was really important to write about the tax reform package that just became law. I want to make this a practical guide and although I might editorialize a little, I think its important to take a pragmatic approach. After all, the bill is now law. We all need to figure out what that means.

So, what’s the name of this tax reform bill which just got passed? The working name was The Tax Cut and Jobs Act of 2017, but since the bill was passed in the Senate using reconciliation, a process that only requires a simple majority instead of a filibuster-proof majority, the Senate Parliamentarian ruled that the name had to change. The office name of the bill is now: An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018. Whew! I will just call it the TCJA. It’s simpler.

Overview of the bill

The TCJA bill has cut taxes to corporations and business, while lowering taxes only slightly for individuals. Corporations have seen their tax rates cut from 35 to 21 percent. Pass-through entities, such as Sole Proprietors, LLCs, Partnerships, and S-Corporations, have also had their taxes cut significantly. Those entities are taxed in the owner’s individual tax returns. There is a new 20% deduction that certain pass-through entities can take, which will lower the taxed income. More on this later.

For individuals and families, rates have been lowered and standard deductions have been raised. This will give some people who don’t itemize their deductions a nice tax break, but there are now fewer deductions for those who do itemize, so those folks might get a much smaller tax cut and possibly no cut at all. In a few cases, people might actually see their taxes rise. Here is a nice summary: Tax Reform Alert 2017.

Tax Rates

The new law does not simplify tax rates. We have the same number of tax rates as we had before, but each of the rates have been lowered slightly.

If you were previously in the 25% tax bracket because your taxable income was $100,000 and you file as a married couple, your new rate would be 22%. So in this case you would pay less than you did before. If your taxable income was $450,000 and you were previously in the 35% tax bracket, then in 2018 you will still be paying 35% (although the deduction changes may also affect you).

Tax rates are indexed for inflation. Previously, the rates were indexed using the Consumer Price Index. The GOP favors the use of a different index called Chained-CPI. The important thing to realize is that Chained-CPI is always lower than CPI. What this means is that tax rates will now be indexed for inflation using an index which increases at a slower rate than before. This means that over time, tax brackets will increase at a slower rate than overall inflation as measured using the CPI. If your salary goes up by CPI, then this might mean you will creep into a higher tax bracket over time.

Deductions and Exemptions

For individuals and families some of the most significant changes were made in the area of deductions and exemptions. First of all, exemptions have been completely eliminated. In 2017, each person in a household was eligible for a $4050 exemption. In 2018 there is no such thing as an exemption. However the standard deduction has been doubled in 2018. The standard deductions were $6,350 for Single and $12,700 for Married Filing Jointly in 2017. For 2018, the standard deductions jump to $12,000 for Single and $24,000 for Married Filing Jointly.

State and Local Tax Deductions

The itemized deductions themselves have also changed. The most prominent change is that the deduction for state and local taxes has been partially eliminated. In 2018 and beyond, you can only deduct state and local income or sales taxes plus property taxes up to a total of $10,000. Many of my readers are in states with high state and local income taxes as well as high property taxes. Unfortunately, this change will be very negative for those taxpayers.

Mortgage Interest Deduction

The mortgage interest tax deduction has also been tweaked. It used to be that you could deduct mortgage interest on a mortgage up to $1,000,000. The new limit has been lowered to $750,000 for new mortgages. Older mortgages are grandfathered in. Home equity loans up to $100,000 used to be deductible, but now home equity loans will no longer be deductible. The change for home equity loans has no grandfathering clause, so if you have one of these loans, your interest will not be deductible in 2018 and beyond. If you have a home equity loan, you should seriously consider refinancing that loan into a new mortgage (assuming the total debt is lower than $750,000).

2% Deductions

There have always been a large number of deduction which needed to be above 2% of your Adjusted Gross Income (AGI). These were deductions for moving expenses, job search expenses, tax preparation expenses, financial advice, and investment management fees. These deductions have all been eliminated.

Medical Deduction

Luckily the medical deduction has been retained and the income limit for this deduction has been lowered for 2017 and 2018 to 7.5% of AGI. That’s right, this change is retroactive to 2017. This will be very helpful for those with significant medical expenses. Remember that insurance premiums paid with after-tax dollars are also deductible under this provision.

Charitable Deduction

The charitable deduction remains and in fact the maximum donation has now increased to 60% for certain cash gifts.

Deduction Phase-out

One last piece of news on deductions. Previous law phased out itemized deductions for income levels above $261,500 (Single) and $313,800 (Married). This phase-out was called the Pease Limitation, named after the Member of Congress who proposed it. The TCJA has eliminated this Pease limitation, so wealthy taxpayers will not see their itemized deductions reduced.

Alternative Minimum Tax

Many taxpayers, who earned middle-class and higher salaries but lived in high-tax states, found themselves subject to Alternative Minimum Tax in addition to their income taxes. The AMT basically throws out most of your deductions and makes you pay a surcharge to ensure you pay enough tax. The important thing to realize is that if you are subject to AMT, then you are not getting as much benefit from your deductions. Most taxpayers truly hate AMT, but unfortunately the TCJA bill did not get rid of it (except for corporations). What it did do, is to raise the exemption amount  and raise the exemption phase-out. The end result should ensure that very few taxpayers will now be subject to AMT. The one exception is those taxpayers who exercise incentive stock options. Those folks might still be hit by AMT.

Other Significant Changes

Child Tax Credit

The Child Tax Credit has been sweetened. It has been raised to a$2,000 credit and phase-out has been raised to $400,000 (married). This is a tax credit, which is much better than a deduction or exemption. Tax credits reduce your taxes dollar-for-dollar, so as long as you qualify, this better credit will benefit you compared to the personal exemption you lost in the new law.

Kiddie Tax

The so-called Kiddie Tax applies to unearned income which children under age 21 earn from investments. In 2017, this unearned income is taxed at the parent rate. In 2018 and beyond, it is taxed at trust tax rates. These rates become 40.8% over $12,500. This will cause a significant problem for those who have put their children’s college savings into a UTMA/UGMA account in their children’s name. Children can also have UTMA/UGMA accounts with money inherited or gifted from relatives. It will be important to deal with these accounts moving forward. College savings can be transferred to 529 plans (where they will be tax free for college expenses). Other funds need to be managed in a tax-efficient manner.

20% Tax Deduction for Pass-Through Earnings

If you own a business which is passed as a pass-through entity (Sole Proprietorship, LLC, Partnership, or S-Corporation), then the good news is that you get to take an extra 20% tax deduction on your pass-through earnings. If you own a personal service business (attorney, dentist, doctor, engineer, architect, financial advisor) then this deduction phases out with taxable income over $157,500 (single) / $315,000 (Married). If you own a landscaping business, or a manufacturing business, or a real estate business (like Trump), then there is no phase-out. This can be a big tax cut, depending on your business.

ROTH IRA Recharacterizations

In 2017, if you made a ROTH IRA conversion, you could decide to recharacterize this conversion (essentially reverse it) later in the year if you changed your mind. This could be because the value of your IRA decreased, but you were paying tax on the conversion at the higher value. The TCJA removes this ability to recharacterize conversions. ROTH IRA conversions will be non-reversible in 2018. No going back and changing your mind.

Estate Tax

One last point is the estate tax exclusion. This has been doubled to $11,200,000 per person in 2018. This makes sure very few people will be affected by federal estate taxes moving forward.

Planning Opportunities

So what does this all mean for you? I have many clients in NY and NJ, who will be affected by the $10,000 limitation on state and local tax deductions. For many of you, this might mean you won’t be able to itemize your deductions in most years. One thing to think about is to “clump” your deductions. You can do this by timing your mortgage, medical, and tax payments as well as your charitable contributions. For instance you could choose to make a large donation in 2018 and make your January 2019 mortgage payment in 2018. If you have any discretionary medical expenses, such as new eyeglasses or dental work, then get that done in 2018. This might push your itemized deductions above the standard deduction in 2018. Then in 2019, don’t bother with deductible charitable donations and put off paying your January 2020 mortgage payment to 2020. Take the standard deduction in 2019. Then itemize again in 2020.

If you donate to charities, they might not appreciate only getting their donations every other year. You can use a donor-advised fund to make sure you can take your deduction every other year, but give the charities their money on a regular basis. Ask your financial advisor (hopefully me!) about a donor-advised fund. Minimum donations are usually between $5000 and $10,000.

Sunset Provisions

Because of the way, the GOP enacted the TCJA without any votes from Democrats, they had to sunset some of the provisions in 2025. This means that in 2025, these tax law changes revert back to the old rules. Which changes revert? It’s all the changes for individuals and families. The tax rate changes for business do not sunset. What does this mean for planning? At this point it’s really unclear. There will be a lot of pressure on Congress to make the changes permanent as this deadline comes closer, but that may or may not happen depending what happens with the economy and politics. Still, something is likely to happen before 2025.

Warm Wishes

As usual, I have probably gone on too long about the Tax Cut and Jobs Act. Unfortunately, its complicated and I have probably just scratched the surface. If you want a quick summary of the act, see this: Tax Reform Alert 2017.

I wish you a relaxing holiday break and a Merry Christmas, Happy Kwanza, Festivus, or whatever you celebrate. Enjoy your family and friends, because they are what makes it all worthwhile!

David J. Haas CFP^®