On December 22, 2017, the president signed and put into law the Tax Cuts and Jobs Act (TCJA). While much more legislation will be required on both the federal and state levels to clarify and correct the new rules, here’s what we know right now…
New lower federal payroll withholding tables will go into effect in February, and in some cases these tables are artificially low. In these situations, even though a taxpayers’ rate of tax will decrease, the taxable income will increase dramatically and the product of the two will be significantly higher. Even so, the payroll withholdings are reduced creating a very real tax trap. This could involve underpayment interest for some taxpayers and will most likely affect middle to upper-middle class families with both spouses working in states with property tax and state income tax (particularly if they have several children).
The Media Is Getting It Wrong
Even the financial media is playing along with this ruse: In a recent Forbes article entitled, “New Tax Withholding Tables Are a Down Payment on Big Middle Class Tax Cuts,” Ryan Ellis describes how the withholding tables have changed and claims this is a pay raise for the middle class. But the author does not explain that this means you withhold less, and not that your tax liability is reduced. Ellis writes, “In fact, the new withholding tables are an immediate pay hike for the middle class,[sic] and portend even bigger refunds to come.” This reporting is deceptive and may lead readers to believe their taxes will be reduced, when in fact only the withholdings will be reduced.
The important point here is that it is critical to evaluate and project your 2018 taxes and withholdings. Some in the middle to upper-middle class are going to be hit hard by the new tax bill, and if they don’t project the effects and compare them with their new lower withholding, they are in for a shock.
Many state income taxes are driven off federal taxable income. Even though the federal rates are reduced, the federal taxable income for many has increased dramatically—this means a significantly higher state income tax. To add insult to injury, the new higher state income tax is no longer deductible for many tax payers. As you might guess, many states are in the process of trying to figure out how to deal with this situation.
The New Bill May Affect Your Taxable Income
Let’s examine some of the key points of this bill. Here are the major changes that could increase your taxable income:
- Personal exemptions are eliminated.
- The state income and property tax total is limited to $10,000.
- All miscellaneous itemized deductions—employee business, tax prep, and asset management fees—are eliminated.
- The mortgage interest deduction is limited to interest on a balance of $750,000 for new loans taken after December 15, 2017, and is on acquisition debt only.
- Moving forward, alimony is no longer deductible to the payor.
There were also some added provisions that could lower taxable income:
- The new Married Filing Jointly (MFJ) standard deduction is $24,000, and the Single standard deduction is $12,000. To this a married couple can add $1,300 for each person over 65; a single person over 65 can add $1,600. This change, along with the limitations or elimination of many popular itemized deductions, will make filing with a standard deduction much more common.
- Charitable deductions are extended up to a limit of 60% of Adjusted Gross Income (AGI).
- The medical expense threshold has been reduced from 10% to 7.5% of AGI.
- There is a child tax credit up to $2,000 for each child under 17, and a family tax credit for dependents 17 and over. The phase out for this credit is a much increased $400,000 AGI for MFJ and $200,000 for Single filers.
- The Alternative Minimum Tax (AMT) threshold is higher. Very few will be AMT taxpayers as the Married Filing Joint AMT exemption amount has gone from $84,500 to $109,400. AMT was much more of an issue in 2017 because personal exemptions and State and Local Taxes (SALT) deductions were AMT preference items that were recaptured, and those deductions no longer exist.
- Many self-employed people will be able to reduce their income by up to 20% of their pass-through income.
- The tax brackets have changed and in most cases reduced, so even a higher taxable income can be taxed at a lower rate. Note that in some cases taxes will rise as the increase in taxable income will not be offset by the lower tax bracket.
How To Improve Your Tax Efficiency
There may be some things we can do now to increase tax-efficiency. Note that charitable deductions are not an AMT preference item, so they are not recaptured even with the higher AMT threshold. As a result, it may be wise to look at grouping charitable deductions into a tax year when they can be higher than the increased standard deduction so that they are more effective.
One popular tool for helping aggregate charitable contributions is a Donor Advised Fund (DAF). This mechanism allows you to decide what year is best for a charitable deduction, and you then contribute to the DAF in that year. The funds go into an account that allows you to make the donation to your ultimate charity at some point in the future. You can also donate appreciated stock to a DAF, eliminating any capital gains on the transfer. Once the funds are in your account, the assets grow until you designate their use by certain charities. Under current tax structure, the deduction can be as large as 60% of AGI for a cash contribution, 30% of AGI for the current value of a donation of appreciated assets, or 50% of AGI for the value of the basis. The gift you make to the DAF is irrevocable, just like any other charitable gift. This mechanism would allow a donor to make on-going charitable grants to a philanthropic cause while grouping the donations into one year. In the interim, whatever funds are not granted to charity are invested for future growth. This can be a complicated subject, so if you’re interested, you should speak with your wealth manager or financial planner to make sure it’s right for you.
In summary, projecting taxes early in the year and setting your correct payroll withholding will be an important planning tactic for 2018 and beyond.
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