Key Thoughts On The New Tax Act
While the Tax Relief and Jobs Act passed late last year, many of us continue to wonder how the law’s sweeping changes will affect us, our clients and the American public at large. We still need to understand how the elimination of deductions, compression of tax rates, and brand new benefits for certain taxpayers will ultimately change the bill we owe to Uncle Sam.
According to the Tax Policy Center, four out of every five taxpayers can expect a reduction, but for many lower income taxpayers, that tax cut will be so little it may hardly even be noticed. And if you live in a high-tax state or you rely heavily on deductions, you are likely to see a tax increase. Every taxpayer will need to assess their individual situation. But in the meantime, here are some initial thoughts and areas that may affect us in some way.
Reduction of the so-called SALT deductions will be most acutely felt in the six states that account for half of the value of these deductions: California, Illinois, Maryland, Massachusetts, New Jersey, and New York, according to the Tax Foundation.
We have run this analysis for our higher-net-worth clients with multiple homes in the past, but this issue should receive more and more consideration given the devastating effects of the tax act on higher tax states. When they were able to deduct property taxes and state income taxes, a typical couple with two homes in one of these high-tax states was able to lower their ultimate tax burden by 25%. Now, their tax burden has actually increased, and these folks may want to consider tax-friendly states such as Texas, Arizona, or Florida.
If your clients are committed to living in a high-tax state and are unable to move or declare residency anywhere else, there are a few tax-smart moves they may get in the habit of using.
Consider bunching deductions, so that clients take the standard deduction one year and itemize the next. By employing this tried-and-true strategy, your clients will be able to take the most advantage of some of those lost itemized deductions. For instance, they may claim the standard deduction in one year, and then prepay their real estate taxes and mortgage payment and fund their charitable contributions the next year, which will enable them to take the full advantage of their deductions.
Goodbye to miscellaneous itemized deductions
The elimination of the deductibility of miscellaneous itemized deductions for tax preparation fees, investment fees, moving expenses, and employee expenses means we should reconsider how and when we pay expenses. Confirm whether your employer is unable to absorb those business or moving expenses that you may currently be paying out of pocket, or perhaps consider cutting back in those areas. Also, taxpayers deduct their investment advisory fees, then consider using your IRA to pay investment fees going forward, which allows them to use pre-tax funds.
If you donate to charity
Charitable contributions are another area that is already getting impacted by the tax law changes. Due to the expansion of the standard deduction to $24,000 per couple, it is likely that fewer people will itemize deductions going forward. Indeed, about 30% of taxpayers currently itemize, and it is estimated that fewer than 10% will itemize in the future as a result of the new Tax Act, particularly if they live in states with little to no income or real estate tax.
Those who take the standard deduction rather than itemizing cannot take deductions for their charitable contributions. What they can do, however, is open a donor-advised fund and prefund it with several years of donations. Once they fund the account, taxpayers can then take one large up-front deduction, potentially itemize that year on their tax return, and then spread the distributions to the charities in future years when they are using the standard deduction. Essentially, it allows taxpayers to separate the act of donating from the actual year of deduction, which is a newish concept, but may make sense under the new law.
And if you have clients that are age 70½ or over, don’t forget the Qualified Charitable Deduction (QCD) which allows a taxpayer to donate their RMD directly to charity up to $100,000 per year, thereby essentially decreasing their AGI.
And speaking of charitable contributions, people have a tendency to write checks to charity, but more and more we want to encourage our clients to contribute appreciated securities to charities, particularly after the recent stock market run-up, and as people are looking to rebalance their portfolios.
If you own a pass-through business entity (lucky you, I think)
Everyone who owns a small business and has pass-through income should be asking what they can do to take advantage of the new 20% deduction aimed at pass-through business owners. By taking advantage of the qualified business deduction, a couple with a small business that has less than $315,000 of income could pay almost $20,000 less in taxes. However, higher-earning doctors, lawyers, accountants and investment managers could have net tax increases after 2017 despite lower tax rates, as they will lose most of their state and local tax deductions.
As a result, we will be urging every client who has large amounts of pass-through income to reconsider whether they should change their business entity to a C corporation to take advantage of the new 21% top tax rate. Service firms that are looking to expand or who have cash flow they don’t need to pay out should look hard at becoming a C corporation. We will also be watching closely to consider other strategies, including income shifting, and otherwise doing whatever it takes to participate in the business tax deduction.
If anyone owns a small business, one of the unintended consequences of the bill is that it may undermine the incentives for small business owners to sponsor a retirement plan for their workers. However, we don’t see it this way, as the lower tax burden on pass-throughs shouldn’t dissuade business owners from the need to plan for and fund their retirement, nor should it act as a disincentive to provide retirement plans to their employees as a recruiting and retention tool.
Careful with Roth’s (but we still love them)
We can no longer recharacterize Roth conversions, which will require you to make absolutely sure that the Roth conversion makes sense at the time of conversion, as there will be no opportunity for a redo. Thus, even if there is a market correction or if the client’s cash flow is tight at tax time, we will be unable to undo the conversion. This means that when we perform conversions in the future, they will require additional thought before converting. Having said that, we still highly recommend the Roth conversions, so this may simply entail doing smaller conversions over a longer period of time, and placing conversions near the end of the year, so that you are not exposed by doing a large conversion and then regretting it if the market pulls back soon afterwards.
Paying the tuition bills?
The final tax bill also expands the use of Section 529 Plans allowing the distribution of $10,000 per year to cover the cost of K-12 expenses, and can provide planning opportunities for those families wanting to pay for private or religious or home school expenses through the use of the preferred vehicle. This allows for additional flexibility and is just another reason that families should be using Section 529 Plans for all types of educational funding.
If you are getting divorced
Beginning in 2019, the tax bill changes the treatment of alimony in one important way. Under the Tax Act, alimony is no longer treated as deductible for the payor, nor is it treated as income for the payee beginning in 2019. Due to this important change, divorcing spouses may consider property settlements over alimony in the future. In addition, the new Tax Act may decrease the transfer of payments or property from one spouse to another, if there is no income tax deduction available to the payor spouse. Obviously, the non-deductibility of alimony needs to be considered in all property settlements and divorce negotiations going forward and I anticipate some creative negotiations and results to arise as a result.
Beginning now every taxpayer should start assimilating their tax documents for 2018 records so that your tax preparer will not miss any opportunities to save you money. We hope that this was helpful and if you are not using our firm for your tax preparations please consider us to be a valuable source.