LUTZ BUSINESS INSIGHTS
New Tax Legislation and Individual Financial Planning Strategies
NICK HALL, INVESTMENT ADVISER
PUBLISHED: FEBRUARY 12, 2018
Admittedly, the US tax code is confusing enough for most of us to keep track of on a yearly basis. Late last fall you likely heard or were following proposed legislations and versions of the Tax Cuts and Jobs Act (TCJA) bill. Both the House and the Senate each had their respective agenda and proposed numerous iterations and edits along the way. What came out of final negotiations and was ultimately signed into law a few days before Christmas were the largest changes to the US tax code since 1986. With these new tax changes, there come financial planning opportunities for individuals and businesses alike.
NEW TAX BRACKETS UNDER TCJA
One of the rallying cries of Donald Trump’s 2016 presidential campaign was lowering and simplification of the tax brackets. Ultimately what came out of the tax code were seven brackets for individuals and families with brackets that were simply trimmed from existing rates. The new brackets that will go into effect in 2018 are 10%, 12%, 22%, 24%, 32%, 35%, and a top rate of 37%. This will bring about a small reduction in marginal tax brackets for most people. The chart bellows shows a comparison of rates from 2017 to 2018:
For trusts and estates, tax brackets were reduced from five to four with the new brackets being 10%, 24%, 35%, and 37%. It is important to note these tax brackets are still very compressed in that it only takes $12,500 of income to reach the top of the 37% tax bracket. Another important change is that the “Kiddie Tax”, for children under 19 or college students under 24, will now have unearned income above $2,100 be taxed at the more compressed trust tax rates rather than a parents’ tax rates. Examples of unearned income could be dividends or capital gains from a UTMA account or distributions from an inherited IRA.
CAPITAL GAINS AND 3.8% MEDICARE SURTAX REMAIN UNCHANGED
One thing that remained the same under the new tax legislation was capital gains and qualified dividend treatment. While TCJA will introduce new tax brackets and slightly different thresholds, the preferential rates for long-term capital gains and qualified dividends will remain unchanged. 0% capital gains rates will end at $38,600 ($77,200 for married filers) even though the 12% marginal tax bracket ends at $38,700. A large majority of you will fall in the 15% capital gains range which goes up to $425,800 for individuals and $479,000 for married joint filers. There are effectively 4 capital gains rates depending on taxable income of 0%, 15%, 18.8%, and 23.8%. This is because the Medicare surtax of 3.8% remains on net investment income for individuals with $200,000 of AGI or $250,000 for married joint taxpayers. Thus, anyone over this threshold pays this tax on top of either the 15% or 20% long-term capital gains rate.
NEW STANDARD DEDUCTIONS AND ITEMIZED DEDUCTION LIMITATIONS
Expanded Standard Deduction: One of the key reforms under the new legislation is a greater standard deduction and repeal of the personal exemptions. Previously, the standard deduction was $6,350 for individuals and $12,700 for married joint filers, with personal exemptions of $4,050 per person. Personal exemptions are now gone, with the standard deduction almost doubling to $12,000 for single filers and $24,000 for married joint taxpayers. This is a huge change that will capture many people under the standard deduction who had previously itemized deduction under the old tax law.
Larger Child Tax Credit: Another new tax provision is the larger Child Tax Credit which will move up from $1,000 to $2,000 per qualifying child under the age of 17. Additionally, the income phase-out for being able to claim this credit will dramatically increase from $75,000 to $200,000 for Individuals and $110,000 to $400,000 for married filers. For example, Sam and Sally Smith have two kids (8 and 11) and have joint income of $200,000 in 2017. Assuming they had itemized deductions of $15,000 and claimed 4 personal exemptions of $4,050 each, they had $31,200 in deductions/exemptions combined. Under TCJA, they will claim the standard deduction of $24,000 but now be eligible for $4,000 of dollar-for-dollar tax credits. Even though the taxes due are $2,016 more because of $7,200 in lower deductions (at their old rate of 28%), the ability to claim $4,000 tax credit for their kids actually lowers tax liability by almost $2,000. In addition to qualifying children, the new tax rules also include $500 credit for “non-qualifying” children like college-aged students who are still dependents or actually dependent parents who are living in your home.
Pease Limitation Repealed: The former Pease limitation, which phased out 3% of higher-earning taxpayers’ itemized deduction above income limits of $313,800 in 2017, was repealed. This will provide a further deduction for high-income individuals whose itemized deductions were limited previously.
Limitation of Itemized Deductions: One of the most hotly debated topics of the TCJA was the proposed elimination of various itemized deductions. The final bill split the difference in a lot of areas. Beginning in 2018, state and local income taxes (SALT) and real estate tax deductions will be limited to a total of $10,000 combined. For high-income individuals/families and those who live in states with higher income taxes or real estate taxes (like Nebraska!) this is a big deal. This led to a rush to prepay real estate taxes and any associated state taxes for 2017 before the end of last year. Additionally, any new mortgage interest after December 15th, 2017 will be capped at $750,000 of debt principal, which is a reduction from the previous $1M of interest on debt principal. One other major change was the repeal of being able to deduct “home equity indebtedness”. There is a caveat though, you are still allowed to deduct interest from drawing on a home equity loan or line of credit to add-on or improve a residence. You just can’t use deduct interest on HELOC for personal spending like a vacation or buying a vehicle.
Repeal of Miscellaneous Itemized Deductions: In addition to limitations on SALT/property taxes and mortgage interest, many popular miscellaneous itemized deductions were repealed. Previously taxpayers could deduct expenses like unreimbursed employee expenses for job travel, tax preparation fees, home office deduction, safety deposit box fees, and investment advisory fees that were in excess of 2% of their AGI. These deductions for individuals were all repealed. Notably, any expense of a business entity or sole proprietorship claimed on Schedule C will still remain deductible though. One recommendation that may have differed from the past is to take any fees associated with pre-tax IRAs or Individual 401(k)s and have them deducted from that account versus a taxable account because you are still getting a full tax deduction in essence (money went in pre-tax and comes out tax-free for investment advisory fees versus otherwise being taxed at ordinary income). Moving expense deductions which could be claimed above-the-line are also repealed in 2018, as is the business’ ability to pay for moving expenses for employees on a tax-free basis.
CHARITABLE BUNCHING AND GIFTING RECOMMENDATIONS
The increased standard deduction and limitations on itemized deductions will capture many more people under the standard deduction going forward. One of the few ways anyone will be able to itemize in a given year is with sizable charitable contributions. It will make sense to utilize donor-advised funds or vehicles such as the Public Community Foundations to pre-fund several years of your charitable giving and lump it into one year. Take for example, Sam and Sally Smith in the previous example who had $15,000 of total itemized deductions previously. If they typically give $4,000 per year they would lose the ability to deduct these contributions because they get a $24,000 standard deduction which would be higher than their itemized deductions. One thing they could do is contribute (perhaps appreciated stock) to a donor-advised fund for $20,000 (which represents 5 years of their gifting needs) in Year 1 which allows them to take the tax deduction now yet gives them the flexibility to gift that money to any 501c(3) charity over the course of the next five years or more. Another important gifting strategy that we will continue to recommend for retirees is the qualified charitable distribution. This is a provision that allows taxpayers to use up to $100,000 annually of their required minimum distributions (RMDs) from their IRAs upon reaching 70 ½ and gift them directly to a charity without the money ever being claimed as income on their tax return. Gifting pre-tax dollars to charities or donor-advised funds are ideal assets to designate to charities because of their tax-preferred status.
MEDICAL EXPENSE DEDUCTION AND HEALTH INSURANCE
The medical expense deduction, a very popular deduction for the aging population, was temporarily expanded to require only expenses greater than 7.5% of AGI for 2017 and 2018, but will revert back to 10% of AGI in 2019. Another less talked about change was the repeal of the individual Obamacare mandate that requires all individuals to obtain health insurance starting in 2019.
LIMITED AMT EXPOSURE GOING FORWARD
The Alternative Minimum Tax (AMT) was not repealed. However, the AMT exemption amounts increased from $55,400 to $86,200 for individuals and $70,300 to $109,400 for married couples. Additionally, there were substantial increases in the income thresholds for individuals and married filing taxpayers ($500,000 and $1M respectively). The limitation of SALT and property taxes of $10,000 on top of repeal of miscellaneous itemized deductions will certainly lower the number of people subject to AMT going forward.
ESTATE TAX & GIFT TAX EXEMPTION DOUBLES
Although the uniform estate and gift tax was not repealed, it was essentially doubled from $5.49M in 2017 to $11.2M per individual. The ability to step up cost basis of appreciated securities/assets upon passing provision remains too for taxable assets. This new exemption amount means very few estates will be subject to estate taxes. However, note there is a currently a sunset provision just like with income taxes that this legislation will end in 2025 if not made permanent. Irrevocable Life Insurance Trusts (ILITs) with 2nd to die policies, which were set up to help beneficiaries pay potential estate taxes, may need to be given a hard look at to determine the need going forward given these larger limits. The old ever popular “A/B” trusts that funded a residuary trust with the estate tax exemption amount (as little as $1M in 2003) at the first spouse’s passing also should be reexamined for all but the largest estates given these new exemption levels and portability between spouses. Lastly the annual gifting exemption amount increases $1,000 to $15,000 for 2018.
POSITIVE CHANGES FOR EDUCATION REFORM AND 529 SAVINGS PLANS
New legislations allows 529 Savings Plans previously designed for college and post-secondary educations expenses to be used now for private elementary school and public, private, and religious high schools. The new provision permits up to $10,000 of distributions per student per year for the elementary and high school levels. There was also an important change with 529Able accounts allowing disabled beneficiaries to now contribute to their own accounts provided they have earned income up to $12,060 as long as they aren’t also contributing to a 401(k) or 403(b) plan. Please, note that Nebraska is one of about half of states who 529 plan did not immediately align with the new federal government rules. There is currently a bill in the Nebraska state legislature to align Nebraska’s law with this new Federal law permitting the use of these funds for lower levels of education.
ELIMINATING RECHARACTERIZATIONS OF PRIOR ROTH CONVERSIONS CLOSES CHERRY PICKING LOOPHOLE
Roth IRA recharacterizations, or undoing a Roth conversion, were initially necessary for those who did a conversion and realized at the end of the year that they were over the income limit to convert to a Roth. In 2010, when the income limits for Roth IRA conversions were repealed this worry went away. What was left were unintended indirect consequences of this rule that allowed people to do Roth IRA conversions earlier in the year and potentially recharacterize if the market went down (very common in 2009 for 2008 Roth conversions). Conversely, it was possible for people to do multiple larger Roth IRA conversions into various accounts and cherry pick the account that did the best after 12-18 months and undo the other Roth conversions. The IRS has cracked down on this rule for undoing any Roth Conversions after 12/31/2017, thus eliminating this strategy. It will be as important as ever to discuss with your CPAs and estimate income toward the end of the year so as to not accidentally bump into a higher tax bracket. On another note, the ability to do “backdoor Roth IRA contributions” or converting nondeductible IRA contributions to a Roth IRA is still available.
With the new tax legislation, we understand there comes more questions and in some sense more complexity from a tax planning standpoint. It is also important to note that many of these new laws have a sunset provision just like the Bush tax cuts of 2001 and 2003. It is our job as financial planners to stay ahead of these laws and offer thought leadership and strategies to consider implementing in your personal financial situations. There are still certain things that need to be discussed with respect to small businesses (S Corps, C Corps, and LLCs) which we will get more clarity with over the coming months. As always, please consult a CPA or other tax professional with any other questions regarding the new tax law or to seek approval about a certain strategy.
Important Disclosure Information
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.
ABOUT THE AUTHOR
NICK HALL, CFP® + INVESTMENT ADVISER
Nick Hall is an Investment Adviser at Lutz Financial. With 10+ years of relevant experience, he specializes in creating thorough, adaptive financial plans and investment management strategies for high net-worth families. He lives in Omaha, NE, with his wife Kiley, and daughter Amelia.
AREAS OF FOCUS
- Comprehensive Financial Planning
- Investment Advisory Services
- Retirement Planning
- Income Tax Planning
- Social Security and Medicare Planning
- Investment Project Research
- High Net Worth Families
AFFILIATIONS AND CREDENTIALS
- Financial Planning Association, Member
- CERTIFIED FINANCIAL PLANNER™
- BSBA in Finance and Business Management, Eller College of Management - University of Arizona, Tuscon, AZ
- Mount Michael Benedictine, Alumni Board President
- Lutz Gives Back, Committee member
- United Way, Volunteer
- Salvation Army, Volunteer
- Omaha Home For Boys, Volunteer
- 2020 + The Year of the Roth IRA Conversion
- The Secure Act + Planning Considerations for Individual Investors/Taxpayers
- Being Mindful of the Social Security Tax Torpedo & Medicare Surcharges
- Qualified Charitable Donations: Using IRAs as a Charitable Piggy Bank for Investors
- New Tax Legislation and Individual Financial Planning Strategies
- The Ins and Outs of Health Savings Accounts (HSAs)
- Sorting Through the Medicare Alphabet Soup
- Is it Time to "Beary" This Bull Market?
- Does a Roth IRA Conversion Make Sense for You?
- Clinton vs Trump: An Impartial Look Into the Tax Plans of Each Candidate
- Tax Deferral: A Very Powerful Financial Planning Tool
- Volatile Markets Can Lead to a Potential Harvest
- Back to School Education Planning
- Taking Social Security Benefits Early or Late: The Great Debate?
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