By Angela Freyman, MBA
“The purpose of a tax cut is to leave more money where it belongs: in the hands of the working men and working women who earned it in the first place.” – Bob Dole
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We’ve watched the campaign promises, the debates, the flurry of activity and our government in action. The biggest tax reform of our generation has just been passed into law. So what does that mean for you? Will you see more money in your pockets, or are the taxes going up for you next year?
For most, the taxes will be going down, at least initially – but those living in high state tax or high property tax states, such as New York (New York City), California, or New Jersey, especially if they are in a higher income ranges, are more likely to see their taxes go up next year. To get a rough estimate if your taxes will go up or down, you can use this handy calculator.
The tax cut that the vast majority of taxpayers are getting for the next eight years or so, is good news for us, but this will also put our country into greater deficit. The jury is out on whether the increased spending and investment will work to counter the growing deficit. The tax cuts are temporary, however, and the pendulum will swing back by the year 2025. If you would like to know more, let’s dive in together and examine just how our taxes have changed.
Rates and Brackets
First off – the tax rates have generally declined, and those earning a salary should, in time, see less deducted for their federal withholdings (it will take a bit of time for the payroll processors to rework their withholding tables). Still, the rates are going down; there remain seven brackets in total, but their break points have been adjusted as well, and work out in taxpayer’s favor.
There are several instances where a taxpayer’s top marginal rate has increased, but the effective tax rate will decline for everyone across the board. That’s because the rest of the marginal tax rates that make up the effective tax rates are down enough to offset any increase at the top marginal rate.
This is how the tax rates and brackets compare for married taxpayers earning below $250,000.
So, a married couple earning $100,000 will have some of their income taxed at 10%, another portion at 12% and their top marginal rate will be 22%, compared to 10%-15%-25% they had faced before. The top marginal rate for married filing jointly (MFJ) filers earning $250,000 declines from 33% to 24%. The highest bracket tops out at 37%, compared to 39.6% under the current system.
The standard deduction has nearly doubled for all filer types. At the same time, many of the familiar itemized deductions have been limited or done away with. This means that a lot more people will be no longer itemizing their deductions beginning in 2018. The changes to the itemized deductions are quite drastic:
- the combined state and local real property tax (SALT) deduction is capped at $10,000; the language of the law specifically prohibits deducting on 2017 tax return, prepaid 2018 state taxes, although you can still pay in the fourth quarterly estimated state taxes for 2017 before the end of this year; tax saving strategy: according to the latest guidance we received from the IRS, if your property taxes have already been assessed, you can prepay them before the end of this year; if you only anticipate the taxes, but have not received a bill for them, then you cannot deduct them on your 2017 tax return
- the mortgage interest deduction limitation is decreased to $750,000, down from $1,000,000 and the home equity interest is no longer deductible; however, if you already have a home acquisition mortgage of over $750,000, it will be grandfathered in
- most miscellaneous itemized deductions have been eliminated, including tax preparation fees, unreimbursed employee expenses, investment fees and expenses, and union dues; these deductions were often limited anyway by the 2% of your adjusted gross income (AGI), and for AMT taxpayers (discussed later) was disallowed.
- casualty and theft losses are now casualty losses, and only apply to declared disasters
- qualified charitable contributions can now be as much as 60% of your income, up from 50% before
- medical deduction is a bit more accessible, with the floor decreasing from 10% of your adjusted gross income (AGI) to 7.5% of the AGI, temporarily – for 2017 and 2018, before it goes back up to 10%. The House Republican plan wanted to repeal this deduction, which would create a huge impact on disabled taxpayers and their families, but it was kept, and improved if only for a few years, under the final bill.
So now, we have a much larger standard deduction, and we anticipate that some taxpayers may be able to achieve greater tax savings by claiming a standard deduction one year and itemizing the following year. They can save all their charitable contributions and medical expenses for the year in which they itemize their deductions. Where feasible, property taxes can also be paid for both years in the year where they itemize their deductions.
Other deductions, known as “above the line” deductions because they are reported on page 1 of your form 1040, and are included in the calculation of your AGI, (as opposed to itemized or standard deduction, which are reported on page 2 and are subtracted from the AGI), are changed as well:
- moving expenses have been repealed
- alimony is no longer a deduction for the payor, nor income to the recipient – but not until 2019
- student loan interest is still deductible on your tax return, with certain limitations – although there was discussion of eliminating this deduction in the earlier versions of the tax bill
Personal Exemption and Child/Family Credits
Under the existing tax system, we calculated our AGI by adding up our income and certain losses and deductions. We then reduced our income by standard or itemized deduction, as well as by a personal exemption for everyone claimed on the tax return, before calculating the tax on our income. In 2015, the personal exemption was $4,000; in 2016 as well as in 2017, the personal exemption was $4,050 per person. However, the exemption gets phased out for individuals with higher income, so a married couple filing jointly in 2017 with income above $436,300 would not see any exemption deducted on their personal return. What’s crucial to understand for any deduction, is that you realize the tax savings at your marginal tax rate. So if you are in the 10% tax bracket, a $4,050 exemption means savings of $405. For a family of four, 4 x $4,050 = $16,200 in exemptions. Which means $1,602 in tax savings.
The exemptions are going away under the new tax rules. They are getting replaced with a larger child tax credit (increasing from $1,000 to $2,000), and a new family credit ($500 per non-child dependent, including taxpayer and spouse). The phaseout for the child tax credit increased from $110,000 to $400,000 for joint filers, so a vast majority of families will be able to benefit from this credit.
An average person would always prefer a credit to a deduction. Credits benefit you dollar for dollar, while deductions benefit you at your marginal tax rate.
A $100 tax credit will reduce your tax bill by $100, whereas $100 deduction will reduce your tax bill by $30 if you are in a 30% tax bracket.
Our typical family of four with two kids, would see a $2,000 increase in child tax credits ($1,000 more per child) and an additional $1,000 in family tax credits ($500 for each spouse).
For families with lower income, the new credit is more beneficial than the personal exemption. However, higher income taxpayers, and taxpayers without children, are losing out. A family of four, with two kids, making $300,000, is in 24% bracket in 2018. With personal exemptions of $16,200 x 24%, they could have saved $3,888 in taxes. Instead, their taxes are reduced by additional $2,000 for the two kids and $1,000 for the two adults. So they are losing ($3,888- $2,000 – $1,000) = $888 under the new system.
There are more details to this change, but we don’t want to put you to sleep!
Alternative Minimum Tax (AMT)
Individuals who claim certain tax benefits may owe Alternative Minimum Tax (AMT). The AMT is a parallel tax system, which was introduced by the Tax Reform Act of 1969 to make sure that the very wealthy don’t skip out on paying their taxes by claiming disproportionately large deductions. The AMT was not originally indexed for inflation, and over time, grew to affect a vast number of middle class Americans. The IRS used to have a tool used to estimate whether you might fall into the AMT but it has been discontinued after the 2016 tax year. The IRS tool could not calculate the amount of the AMT you would owe, because the calculations are very complex, and are specific to each individual scenario.
Republicans proposed eliminating this tax, in order to simplify the tax code. The AMT has not been eliminated, but it should no longer apply to the typical middle class taxpayers. The AMT exemption amounts as well as the exemption phaseout have increased under the plan. However, the AMT is not a straightforward tax in any way, and there are other factors playing into the calculation. Some high income individuals with high deductions may not land in AMT, while someone with much lower income, might still fall under the alternative tax.
If you would like to see how the AMT changes will affect you in 2018, please contact our office.
Section 529 Plan used to only allow qualified expenses paid for higher education tuition, room and board, fees, books and supplies (with certain limitations). The 529 Plan now also allows distributions of up to $10,000 for qualified expenses for elementary/high school.
Each year, you may qualify for a Lifetime Learning or American Opportunity credit for each student who is on your tax return. Both credits have been retained, which are great news for lower-income taxpayers facing college expenses for themselves or their children. The American Opportunity credit is up to 40% refundable credit, while the Lifetime Learning credit is a nonrefundable credit which can be used to offset tax due.
ABLE accounts are tax-advantaged savings accounts for individuals with disabilities and their families. Income earned in this account will not be taxed. The purpose of ABLE accounts is to allow disabled individuals and their families to have savings account, subject to limitations, to address additional expenses related to living with disabilities, without losing the SSI or Medicare benefits. The ABLE accounts have been enhanced to allow rollovers from 529 accounts to ABLE accounts. Thus, if a 529 plan was opened for a beneficiary who is determined to be disabled, these funds can now be transferred, without penalties, to the ABLE account. In addition, the beneficiary (the disable person) will receive a tax credit for contributions made by anyone into this account.
Although the Republicans were not able to repeal the Affordable Care Act (ACA) earlier this year, the tax reform eliminates the individual mandate. There will no longer be a penalty if you did not have insurance coverage.
There are good reasons to convert a traditional IRA to a Roth IRA, according to Fidelity Investments. Among them is a Roth’s tax-free growth potential and the ability to take tax-free withdrawals in retirement. However, there also may be reasons to reverse a Roth IRA conversion. For instance:
- The value of investments in the converted Roth IRA has declined
- Higher than expected taxable income and/or the additional income from the Roth IRA conversion resulted in a bump to a higher federal income tax bracket
- Taxable income in retirement will likely be lower than expected, reducing the potential benefits of a Roth IRA’s tax-free distributions
- Not enough cash on hand to pay the taxes
The process of reversing a Roth IRA conversion is known as recharacterization. After 2017, Roth Recharacterization can no longer be used to unwind a Roth conversion. You can still, however, recharacterize Roth contribution to the traditional IRA plan, if, for example, the contribution to Roth was made in error. If you believe that you may need to recharacterized a previously converted Roth IRA, you need to do so before 12/31/17. Contact our office if you believe this applies to you.
As a final point, most of the provisions in the bill expire at the end of 2025, which was necessary to keep the bill from adding more than $1.5 trillion to the deficit. Congress could certainly choose to extend them before they run out, but it’s important to be aware that these aren’t permanent tax changes.