Tax Planning for Individuals after the Tax Cuts and Jobs Act
Jean McDevitt, Tax Principal
The passage of the Tax Cuts and Jobs Act (“TCJA”) in December of 2017 generated some of the most significant tax law changes seen since the Tax Reform Act of 1986. While we await further guidance in the form of Treasury Regulations and many questions remain as to how to apply the new rules, we attempt here to shed light on some planning options as we look ahead to the remainder of tax year 2018.
Rethink Tax Deductions
Congress has revised the tax deduction landscape for all individual taxpayers. The standard deduction has been increased significantly (from $12,700 to $24,000 for married taxpayers) which is a boon for taxpayers with deductions that typically fall below that upper level. However, as the TCJA giveth it also taketh away: TCJA has minimized or eliminated many itemized deductions for individuals.
In particular, there is a new cap of $10,000 on an individual’s deduction of state and local taxes. For taxpayers in states with a high income tax rate and/or high property taxes, this may be a significant tax hit. So-called 2% miscellaneous itemized deductions have also been eliminated - notably including investment fees and tax preparation fees. While this will negatively impact some taxpayers, for others the change may yield a wash. Under old law, many taxpayers didn’t realize a benefit from such deductions due to income phase outs and Alternative Minimum Tax. While it’s not possible to simply spot which taxpayers will be harmed and those that will not, a running of the numbers for a specific taxpayer situation is telling.
The new changes to the itemized deductions also present an opportunity for some taxpayers to rethink how and when they make many of their charitable gifts. For example, let’s assume that a married taxpayer in 2018 pays property tax of $11,000 and state income tax of $6,000, and makes an outright charitable contribution of $6,000. The taxpayer’s itemized deductions total only $16,000 ($10,000 cap for the state and local taxes plus $6,000 for the charitable contribution). The taxpayer’s standard deduction meanwhile is $24,000. The standard deduction provides a greater benefit and will be used. In this example, the $6,000 charitable contribution really provides no income tax benefit.
One strategy is to bunch together charitable gifts in a particular tax year and reduce giving in subsequent years. This will maximize the likelihood that your charitable contributions will help reduce your income tax bill. One may take this strategy a step further and consider using a vehicle to help facilitate bunching such as a donor advised fund (DAF). DAFs are centrally managed by an investment custodian and the funds are doled out to charities as you request. However, as the donor, you receive the entire tax deduction in the year that the funds are transferred into the DAF. For even larger sums and additional goals in mind, one might consider a Private Foundation. Other vehicles such as pooled income funds, charitable gift annuities, and charitable remainder trusts provide income tax benefits while also providing an income stream and adding an estate planning element.
Another option for a taxpayer to consider is making a Qualified Charitable Distribution (QCD) from his or her Individual Retirement Account (IRA). To qualify for this favorable tax treatment, the taxpayer must be over age 70 1/2 and the transfer must be made directly from the IRA custodian to the charitable organization. The amount that may be transferred via QCD is limited to $100,000 annually per taxpayer. The QCD often provides the most “bang for the buck” as the distribution is not brought into income, which insures that the entire tax benefit is realized. In certain cases, this giving technique may also provide a reduction in net investment income taxes and state income taxes.
Know Your True Tax Rate
With the changes in deductions, one may think it’s easy to identify whether he or she is a “winner” or a “loser” under this new tax law. But we need to look beyond the mere loss of deductions, because there were also changes to the tax rates and bracket structure. While we retained seven different tax brackets, the top bracket was reduced from 39.6% to 37% and the middle brackets went from 25%, 28%, and 33% to 22%, 24%, and 32%. However, the levels at which each rate applies have also changed. And to further complicate matters, there were some positive changes to the Alternative Minimum Tax structure.
A review of your projected income tax liability now, in advance of year-end, may well make sense. Many individuals with tax withheld by their employers may have noticed a net reduction in withholding in early 2018. This was a result of the IRS revising the tax withholding tables. A reduction in an employee’s withholding may be the result of the tables but not an accurate portrayal of one’s ultimate tax liability when all factors are considered. We find “running the numbers” using our tax projection software is necessary to know the true impact of these changes on a specific case.
The reduction in the allowable deduction for state and local taxes may cause some folks to consider abandoning their current state domicile and opting to move to a state with lower or no state income taxes and/or property taxes. We counsel clients to consider this planning technique with an eye towards the reality of their lives. For taxpayers who already are spending significant portions of their time in another state and have ties there, it may be a relatively simple tax planning tool that nets real dollars. Each taxpayer’s situation is unique, however, so we encourage you to have an in depth conversation with your tax advisor before commencing on this path.
New Home Mortgage Debt Limits
The new tax law limits the deductibility of home mortgage interest in certain situations. For BNN’s thorough discussion of those provisions see Mortgage Interest: What’s Deductible Now and Should I Refinance? Taxpayers who anticipate running afoul of the lower principal loan limits or the home equity limitation may want to consider restructuring the debt.
For clients going through a divorce, tax planning may not seem necessary. However, agreements pursuant to a divorce often contain provisions that can have a significant tax impact. We encourage clients to provide us an opportunity to review draft agreements to help advise on tax implications.
With the new tax law, it’s important to note that for any agreement entered into after December 31, 2018 (or an existing agreement that is modified after that date), alimony received will no longer be includible in the recipient’s income nor will it be deductible by the payer.
TCJA implicates changes for taxpayers with children of the marriage. Typical divorce agreements allocate the personal exemption allowable for children to a specific parent, which in the past may have yielded tax savings to that parent. However, under the new law, personal exemptions are no longer allowed. For existing agreements, this is detrimental to the parent entitled to claim the exemption. To add a further wrinkle, the TCJA individual provisions are scheduled to sunset after 2025 so this tax treatment may be temporary. Any new divorce agreements or modifications should contemplate such changes in the law going forward and build flexibility into the agreement.
Divorce agreements also typically address who may take certain child tax credits. Note that the child tax credit under TCJA has been greatly expanded allowing a higher dollar amount credit for eligible children. Again, this is something that needs to be addressed in any agreement, which should likewise contain an element of flexibility as tax law changes over time.
Because of the reduction in tax rates, it may be that a particular individual’s contributions to tax deferred retirement plans and traditional IRAs are less valuable from a tax reduction standpoint. Taxpayers in that situation may want to revisit their ability to contribute to a Roth 401(k) with their employer, consider a Roth IRA contribution, or a so-called “backdoor” Roth for those above the income limitations for regular Roth IRA contributions.
This may also be a good time to revisit the opportunity to convert funds in an existing Traditional IRA to a Roth IRA. Such a conversion may generate a large income tax liability but given the reduction in tax rates, it may behoove some taxpayers to consider the move.
Taxpayers considering a conversion to Roth should be aware of another significant change under the TCJA. Under old law, taxpayers who engaged in a Roth conversion had the ability to essentially undo the conversion through a “recharacterization” of the conversion. For example, if a taxpayer converted a $100,000 Traditional IRA to a Roth IRA in 2016, the taxpayer had until October 15, 2017 to recharacterize the amount back to a Traditional IRA. This was helpful in situations where the conversion happened at a high point in the asset value and then due to market fluctuations the value was considerably less sometime after the conversion. Under TCJA this type of recharacterization is no longer allowed so taxpayers must be aware that the tax liability associated with such a conversion remains fixed even if the underlying assets have diminished in value.
There are a number of TCJA business related provisions that will also impact individual taxpayers. In particular, the lower tax rate for C corporations and a new deduction allowed for pass-through entity income may provide many opportunities for restructuring existing entities as well as setting up new entities. A significant amount of guidance is anticipated in the near future so stay tuned while we await - hopefully instructive - Treasury Regulations. For a thorough review of the known details, please see our articles on those topics:
- Are C Corporations More Attractive Now that the Rates Have Dropped?
- A New 20% Deduction for Qualified Business Income of Flow-thru Entities
- Proposed Section 199A Regulations are Issued
Qualified Opportunity Zones
Individual taxpayers may also benefit from a new tax incentive if interested in investing in low-income communities. The law allows taxpayers to defer capital gains tax on the sale of assets if the funds are reinvested in a designated Qualified Opportunity Zone through a Qualified Opportunity Fund. The gain may be permanently excluded if the investment in the Qualified Opportunity Fund is later sold. The permanent exclusion is subject to a number of timing rules. See more detail at our earlier article: New Opportunity Zones: Tax Deferral and Permanent Exclusion of Capital Gains.
The new tax law contains significant taxpayer-friendly provisions in the estate and gift tax planning arena. The TCJA doubled the amount of the combined gift and estate tax exemption from $5 million to $10 million (inflation-indexed for 2018 to approximately $11.18 million). Note, however, that doubling only lasts through 2025. If indeed, the increased exemption goes away (at the end of 2025 or earlier if a new administration comes in and pushes a change through) then this increase is essentially a “use it or lose it” benefit. For taxpayers with net worth in excess of $5 million, planning should be considered in light of this opportunity.
Married taxpayers may want to consider spousal lifetime access trusts (SLATs), which if structured properly can utilize the increased exemption amount while maintaining the assets in a trust structure that offers some access to the donor’s spouse. Domestic asset protection trusts (DAPTs) may be a useful tool for unmarried taxpayers. Both of these structures are irrevocable and require the donor to relinquish control and management over the trust assets. Such tools should be undertaken only with substantial discussion and planning.
Tools such as GRATs, sales of assets to trusts, and charitable estate planning vehicles are still all viable techniques that should be considered by certain taxpayers in this new estate planning landscape.
Taxpayers should note that while the exemption amount increased, we also retained basis step-up for assets held at death. The basis step-up provides that property passing to an heir has a cost basis in the hands of that heir equal to the fair market value on the date that the decedent passed away. Effectively, the heir could sell the asset the next day and realize gain equal only to the difference between the then fair market value and the value on the date of death - typically, zero.
If instead, the taxpayer had gifted those assets during life, the recipient takes the property with the taxpayer’s cost basis. That would likely yield a very different result. The recipient upon sale of the asset would realize taxable gain equal to the then fair market value less the taxpayer’s original basis (or adjusted depending upon the type of asset). Therefore, in using the increased federal exemption, it’s essential to “run the numbers” to be sure that an estate tax savings isn’t realized at the cost of a higher or equally high income tax burden borne by the recipient of the property.
A third area to consider is the impact of state law on one’s estate tax planning. Both residency/domicile and the location of assets come into play when determining a possible state estate tax liability. While many states conform to federal estate tax law, many states (of particular note to us in the northeast: Maine, Massachusetts, Vermont, Connecticut, New York, Rhode Island) have much lower exemption amounts than the federal level. This may require a particularly hard look at comprehensive estate planning for those clients with net worth higher than the relevant state exemption amount.
This is not an exhaustive list of the changes made impacting individual taxpayers, but instead an example of how we might approach such a planning conversation with a client. We encourage you to reach out to your BNN advisor if topics raised here or other concerns are on your mind. We welcome the opportunity to help guide you through this changing tax landscape!
If you have any questions regarding the Tax Cuts and Jobs Act and its impact on individual tax planning, please contact Jean McDevitt or your BNN tax advisor at 800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.