10 changes to the tax code that you should be aware of
With President Trump’s signing of the Tax Cuts and Jobs Act on December 22nd, many of our clients are still wondering what has really changed and, more importantly, which changes will personally impact their taxes going forward. The good news is that most of us will pay less federal income tax under the new tax code. The bad news is that for many taxpayers, the reduction in tax paid will be less than we were initially led to believe. Here are 10 changes that are likely to impact many of our clients.
Tax Bracket Revisions
Elimination of Personal Exemptions
Increased Child and Dependent Tax Credits
Increased Standard Deduction
Changes to Itemized Deductions
Reduced Tax on Pass-Through Income
Expanded Use of Section 529 Education Savings Plans
Higher Estate Tax Exemption
Higher Alternative Minimum Tax (AMT) Exemption
Elimination of the Health Insurance Mandate (beginning in 2019)
#1 – Tax Bracket Revisions
While initial plans for a reduction in the number of tax brackets didn’t come to fruition, for most people, the new tax brackets will still be a positive change. If a couple’s taxable income (after deductions) is below $315,000 ($157,500 for a single person), then they will experience a reduction in their overall tax burden. As an example, a couple with $100,000 of taxable income on their 2017 tax return might pay about $16,500 in tax, but that same couple would only pay about $14,000 in tax on their 2018 return with the same amount of taxable income. The chart below summarizes the tax bracket changes.
Source: Robert W. Baird & Co.
It’s also worth noting that the capital gains tax rates of 0%, 15% and 20% have remained unchanged, though they are now based on their own taxable income levels rather than being tied directly to any of the income levels for brackets shown above (as they were previously).
#2 – Elimination of Personal Exemptions
This change is often glossed over in the news reports, but it’s a big one – especially for anyone who has qualifying dependent children over the age of 16 (such as children who are in high school and college). Under the 2017 rules, each filer and their qualifying dependent can claim an exemption of $4,050. That means that a family of five received $20,250 in exemptions that effectively reduced their taxable income. Under the new tax code, that drops to $0. In theory, the loss of exemptions is covered by changes noted in #3 and #4 below, but for families with dependent children ages 17-23, the changes noted below will not fully compensate for this elimination of personal exemptions.
#3 – Increased Child and Dependent Tax Credits
As noted above, this change is intended to help offset the elimination of the personal exemption amounts for taxpayers with children age 16 or younger. The tax credit per qualifying child has increased from $1,000 to $2,000. Unlike exemptions and deductions, which reduce the amount of income that is taxed, this credit is a dollar-for-dollar reduction of tax. This change will be a net positive for taxpayers who were previously in the 15% or lower tax brackets (now the 12% and 10% brackets) because the true tax benefit of a $4,050 exemption when you are in the 15% tax bracket is about $600 ($4,050 x 15%), but they now receive $1,000 more in tax credits instead. For tax payers who were in the 25% tax bracket, this credit increase is an equal offset to losing the exemptions, but to those who were in the 28% or higher tax brackets, this tax credit increase does not fully replace the lost benefit they received from each personal exemption.
The new tax code also creates a $500 tax credit for individuals who are not your dependent children, but who could qualify as dependents based on meeting certain tests related to the amount of support you provide to them, their relationship to you, and how much income they have. Similar to the increased child tax credit, this new credit is meant to help offset some of the benefit that was lost when the personal exemption deduction was eliminated.
#4 – Increased Standard Deduction
Other than the tax bracket changes, this change is probably the one you hear about the most. However, unlike the tax bracket changes, this change will not benefit as many people. If you already use the “standard deduction” each year, rather than itemizing your deductions, then the approximate doubling of the standard deduction from $12,700 for a married couple in 2017 to $24,000 now in 2018 ($12,000 for a single person) is likely to be a net benefit to you (unless you have dependent children age 17-23, as noted above).
If you traditionally itemize your deductions because they have exceeded the standard deduction amount, then the benefit of this increase to the standard deduction will not be as big of a benefit for you, and you could even be worse off in some cases. Here are two contrasting examples to show why this is true:
Couple A has no children and has $14,000 of itemized deductions for 2017 (which exceeds the $12,700 standard deduction). By combining their itemized deduction amount with the two personal exemptions they receive ($4,050 each), they will get a combined benefit of $22,100. Under the new tax rules for 2018, this same couple will lose their personal exemptions, but their standard deduction amount will go up to $24,000 (they will not itemize anymore since the standard deduction is higher). For this couple, the tax law change results in a reduction of their taxable income by $1,900.
Couple B is not as fortunate. They have a large mortgage and make significant charitable contributions each year, so their itemized deductions for 2017 are $20,000. They also have two dependent children who are over the age of 16, so their exemptions for 2017 total $16,200 ($4,050 x 4). The combination of these two benefits reduces their taxable income by $36,200 in 2017. Now roll the calendar forward to 2018 – they will take the standard deduction of $24,000 since it exceeds their itemized amount, and they will lose the personal exemption deductions. Their overall income reduction is now $24,000 for 2018 (the standard deduction), which is $12,200 less than the prior year even though their circumstances have not changed. If they are in the 22% tax bracket, this equates to paying an extra $2,684 in tax (which could effectively wipe out any benefit they received from the new lower tax brackets).
While it may have been unintentional, it is clear that many taxpayers will be negatively impacted by the elimination of the personal exemption, even with the increase to the standard deduction amount.
#5 – Changes to Itemized Deductions
While the increase to the standard deduction amount will eliminate the need to itemize deductions for many taxpayers, there will still be some who have high enough deduction amounts to continue to itemize. For those who do, here are some of the changes that are likely to impact them.
The combined deduction for taxes paid on non-business property (such as your home) and for state sales or income tax will now be capped at $10,000. Prior to 2018, there was no limit.
For mortgages that began after 12/15/2017, the deductible interest will be limited to the amount attributable to the first $750,000 of debt. For mortgages entered into prior to that date, the amount remains at $1M.
Interest paid on all other home equity loans will no longer be deductible, and this applies to both existing and new loans.
For 2017 and 2018 only, out-of-pocket medical costs will be deductible to the extent that they exceed 7.5% of your Adjusted Gross Income (AGI is the amount shown at the bottom of page 1 of your tax return), which is actually better than the 10% threshold that existed previously.
The annual deduction for certain charitable donations is now set at 60% of your AGI, which is also an improvement over the 50% limit that applies to 2017.
Several itemized deductions will no longer be allowed starting in 2018, including tax return preparation fees, investment management fees, union dues, safe deposit box fees, losses from theft or casualty (except in a federal disaster area), and moving expenses.
#6 - Reduced Tax on Pass-Through Income
The final bill provides for a 20% exemption of net income (other than W-2 wages) from “pass-through” business activities. This includes income from self-employment (sole proprietor), a Partnership, an S Corporation, or an LLC. At this point, the new law doesn’t appear to distinguish between income from a business you are actively involved in, or from a passive source like an investment in a Real Estate Investment Trust (REIT) or a Limited Partnership. There are potential limits on the amount of the deduction based on the amount of wages paid by the business, or a combination of wages and depreciable property owned by the entity, but that calculation goes beyond the scope of this blog, so be sure to consult with your CPA if you believe this applies to you.
Unfortunately, this exemption will also be reduced or eliminated for income from a business that provides services in the field of health, law, accounting, consulting, and other businesses where the primary “product” is the knowledge, reputation or skill of the employees. The 20% deduction for income from these types of businesses will be phased out for a couple with over $315,000 of taxable income (completely phased out at $415,000), and for single taxpayers with over $157,500 of taxable income (completely phased out at $207,500). Notable exceptions to this rule are Engineering and Architecture businesses, which are not subject to this phase out.
#7 – Expanded Use of Section 529 Education Savings Plans
Up to $10,000 per year can now be withdrawn tax-free from Section 529 education savings plans to pay for qualified of K-12 expenses related to public, private or religious schools. Previously, tax-free withdrawals were only allowed for qualified costs incurred at the college level.
#8 – Higher Estate Tax Exemptions
High net worth individuals (and their heirs) will benefit from a significant increase in the estate tax exemption…at least until 2026 when the temporary increase is set to expire. Prior to the new law, the exemption amount for 2018 was going to be approximately $5.6M per person ($11.2M for a couple), but that exemption has now doubled to $11.2M per person ($22.4M per couple).
#9 – Higher Alternative Minimum Tax (AMT) Exemption
While the final bill did not entirely eliminate the AMT, it did increase the AMT exemption amount for couples from $84,500 in 2017 to $109,400 in 2018, and from $54,300 to 70,300 for single taxpayers, which should reduce the number of people subject to AMT. Similar to the changes in the estate tax exemption, this one is also set to revert back to the lower levels (adjusted for inflation) after 2025.
#10 – Elimination of the Health Insurance Mandate
Beginning in 2019, the penalty for not having every member of your household covered by health insurance will be set to $0, which effectively eliminates the mandate for health care coverage originally imposed under the Affordable Care Act that was passed in 2010.
In summary, the list above is not intended to cover every tax code change enacted by the Tax Cuts and Jobs Act, but does identify changes that are likely to impact many of our clients. While there are a significant number of changes coming, and one or more of them will impact every taxpayer, many taxpayers will also experience offsetting adjustments that will reduce their bottom line tax impact next year. Due to the volume of these offsetting changes, and the uncertainty that remains around the final application of some of these rules, you should consult your CPA or one of our financial advisors before making any financial decisions based on these tax code changes.
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