As you have likely read various articles over the past few days, the Tax Cut and Jobs Act (“2017 Tax Act”) passed and makes some significant changes to both personal and business income taxes. While the impact to each taxpayer will vary based on individual circumstances and while tax regulations have yet to be developed, there are general observations to make.
Many of the individual tax law changes are set to expire after 2025 (under the Sunset rules), unless the laws are changed before then. As we like to say in this arena, tax laws are semi-permanent until changes are made. As in the past, tax planning should continue to be done on a multi-year basis with a proper analysis of current and future years’ potential income and deductions. It is important to stay flexible in your tax planning and look at your individual situation for both today and tomorrow. The following touches on a few highlights and is obviously not an exhaustive review of the new tax law.
Tax rates and brackets. In general, the tax rates have decreased and generally apply at lower income levels. While the rate reduction is not significant, the 1% to 3% tax reduction will be beneficial for most tax filers. The marginal rates will actually be higher for certain taxpayers, i.e., joint filers that make between $400,000 and $424,950 and single taxpayers between $200,000 and $424,950.
- Thus, in some cases, it may be preferential to defer some income into 2018 and/or accelerate deductions into 2017, all else equal.
Standard Deduction and Itemized Deductions. One of the more surprising and potentially impactful changes was the increase of the standard deduction to nearly double the previous amounts (Married Filing Jointly: $24,000; Single: $12,000).
- This will likely result in less taxpayers itemizing their deductions. Thus, if you plan to itemize your deductions in 2017 but are likely to use the standard deduction in 2018 and beyond, you may find it beneficial to accelerate some of those deductions in 2017, e.g., charitable contributions, property taxes, state income taxes, and miscellaneous itemized deductions.
- Bunching deductions, i.e., making more deductions in one year versus the next, may become more relevant for some taxpayers. In this situation, the taxpayer might itemize deductions in Year 1 and utilize the standard deduction in Year 2, or vice versa. For those charitably inclined, donor advised funds may see an increased role in tax minimization. In light of these planning opportunities, one should not automatically assume that itemized deductions will not apply to them – to do so may cost your household a considerable amount in income taxes over the long-term.
Changes to Certain Itemized Deductions. For those that will still itemize deductions in 2018 and beyond, there are important notes about some itemized deductions. The medical expense AGI threshold reverts back to 7.5% of AGI from 10% of AGI (through 2019). For state and local taxes, this deduction is now limited to $10,000 (rather than unlimited previously) and can be composed of just state and local income taxes and property taxes. Tax prep fees (boo!) and employee business expenses are no longer allowed. Regarding interest deductions, while mortgage interest is capped for “acquisition debt” of $750,000 (for new debt), taxpayers will no longer receive deductions for home equity loans.
- If you planned on making major purchases next year, perhaps 2017 is a good time to make that purchase to be able to utilize the sales tax deduction in 2017. (This small tax break alone should not be sufficient justification to buy that new yacht!) If you happen to be paying state income taxes (for 2017) or are in a jurisdiction that allows you to prepay property taxes, it may be beneficial to pay the total amount by December 31, 2017.
- It may also be beneficial to accelerate those miscellaneous itemized deductions in 2017 since they will not be available next year.
- You may want to revisit your debt management. While there should continue to be a review of multiple factors in reviewing the amount and structure of your debt (investment arbitrage opportunities, emergency fund needs, variability of rates, cash flow needs, peace of mind), the income tax part of the equation should not be ignored. While some may rush to pay down the mortgage, keep in mind that these rules could change and the ability to strategize by bunching deductions may continue to allow mortgage interest to be a viable tax play. With the (current) elimination of home equity interest deductions, perhaps utilizing more permanent debt for new acquisitions is preferable to a home equity loan in certain situations.
- Note that phaseouts of itemized deductions that previously applied to high income taxpayers no longer apply in this new tax structure. These phaseouts have come and gone with different administrations so we should not be surprised if they make their way back into the tax code.
Personal exemptions are eliminated. This was also a big change and significantly offsets the benefit of the increased standard deduction for many taxpayers. High income taxpayers no longer have to worry about phaseouts.
Preferential capital gains and dividend rates. These rates have remained intact; however, the income levels at which the 0%, 15%, and 20% rates apply have increased in some places.
- There continues to be planning opportunities around selling appreciated assets. In addition to various charitable techniques and other tax deferral strategies, structuring or timing the sale of an asset based on anticipated income could help minimize capital gains taxes for certain taxpayers.
The kiddie tax is more onerous. The tax rates that apply to income earned by a “child” will be based on the trust and income tax rate schedules rather than that of the parents. These rates are generally more burdensome as the top tax rates kick in at a much lower income threshold.
- The ability to decrease taxes by income-shifting becomes even more difficult for taxpayers, but this should continue to be reviewed.
AMT Tax - Personal. The personal AMT tax will still be around, but the AMT exemption was moderately increased. For many in states with low income taxes such as Tennessee or Florida, the AMT tax was, and still is, less relevant. The personal AMT tax cannot be ignored, however, since this tax system is still around.
Child Tax Credit. The child tax credit has been increased to $2,000 per qualifying child (up from $1,400). And, perhaps more significantly, this partially refundable tax credit is now available to higher-earning taxpayers. The phase out of this credit now starts at $400,000 (joint filers – up from $110,000) and $200,000 (single filers – up from $75,000).
- There are a lot of details behind these rules, but this may generate considerable additional dollars for those with children. From a planning perspective, you need to weigh the costs of additional children with the expenses that such children bring. That advice is free.
Changes to C corporation rates. This is one of the more significant changes in the tax act. The tax rate that applies to C corporations was changed to a flat rate of 21%. Previously, the rate was as high as 35%.
- This may impact the choice of entity for business owners. Although C corporations are still subject to double taxation (corporate level and shareholder level), C corporations are now more attractive than they were previously. Couple this lower rate with a previously seldom-used provision that allowed a certain amount of capital gains to be excluded on the sale of C corporation stock, and C corporations may become more popular for certain businesses.
- There are many other provisions impacting businesses (e.g., change in NOL rules, repeal of corporate AMT, more favorable depreciation rules, change to a more territorial tax system as it relates to international operations) that should be considered.
Pass-through entity deduction. Individuals that own pass-through entities may receive a tax break – they may now deduct up to 20% of “domestic qualified business income” from certain pass-through entities. High income taxpayers are limited in the amount of the deduction and certain service businesses are not eligible, however.
- Choice of entity will continue to be an important consideration for tax-planning purposes. And, individuals who were employees may find it more beneficial to become independent contractors under various circumstances.
Increase of gift and estate tax exemptions. While the estate tax applied to very few individuals before this legislation, the new laws -- which increased the amount one can leave to heirs to $10,000,000 (adjusted for inflation) -- make it even less applicable to most Americans.
- Of course, there are still many other non-estate tax reasons to do proper estate planning, and the increase in estate tax exemption could impact how your estate flows based on the wording of your documents. In particular, there is often more of a focus on minimizing income taxes at death rather than estate taxes. Thus, if you have not reviewed your estate plan in some time, it is a good time to revisit your documents.
- For those that were making transfer to reduce one’s taxable estate, it may be wise to revisit whether such gifts continue to make sense. In some cases, more aggressive gifting may be wise; in other cases, it may be better to discontinue gifting so that assets retained in your estate can receive a step-up of basis to fair market value at your death.
Other changes include changes to moving expenses, 529 Plans, elimination of the health care insurance penalty in 2019, alimony deduction and inclusion rules, reduced ability to recharacterize conversions to Roth IRAs, AGI limitations on charitable contributions, and personal casualty losses, among others. Certain changes that were discussed did not make it in the 2017 Tax Act, including eliminating the Unearned Income Medicare Tax and a reduction in deferrals available to tax-deferred retirement plans.
Thus, take advantage of what the 2017 Tax Act may offer you over the next few years but realize that flexibility is the key in making decisions over the short-term and long-term. Continue to work with your wealth advisor and CPA to structure a plan that is beneficial for your situation and then reevaluate when tax laws are revised yet again.
You can also view Fidelity’s resources for further information: (http://bit.ly/2zzhwB0).