In the midst of all the reports on separate House and Senate provisions, it’s no wonder that many are confused by the looming changes. Here are some of the more significant ones that apply to individual investors.
WASHINGTON — The news about the proposed tax reform bill has been dizzying.
One reason that there’s so much interest in the bill is the change in actual income tax rates. In general, the higher your income, the more likely you’ll benefit from these rate changes. Individuals will benefit from a decline in the top tax rate, from 39.6 percent to 37 percent; the top corporate rate of 35 percent may be reduced to 21 percent.
Similarly, pass-through businesses (including partnerships, LLCs, and S Corps) whose owners pay taxes according to the individual tax rate schedule, may now be allowed a 20 percent reduction in pass-through income. The goal of these changes is to cap their businesses’ tax rate at 25 percent, rather than having to pay the higher ordinary income tax rate. Personal service partnerships and sole proprietorships are specifically excluded from this rate reduction.
Large public companies also stand to benefit from changes to the deductibility of compensation they pay to the CEO and three of their most highly compensated employees. Currently, there are limits on the amount employers can deduct for compensation to these employees when they earn over $1 million annually in performance-based compensation. New legislation eliminates these deduction restrictions, thus providing potential benefits to public companies with higher-paid executives.
One final benefit to businesses is the elimination of the corporate alternative minimum tax. Unfortunately, the individual alternative minimum tax (AMT) remains. The good news is that fewer people are expected to pay individual AMT under the new plan, because the exemption phase-out will be raised to $1 million for couples and $500,000 for an individual.
2. Changes in itemized deductions
In addition to tax rate changes, the bill is expected to reduce the actual after-tax income of filers who sit at the lower and upper extremes of income. These changes have been widely publicized because they impact many Americans. The Dec. 13 combined bill surprised some CPAs and attorneys with new limits that may give a reason for wealthy clients to more carefully review year-end tax projections, especially if they have significant itemized deductions. That’s because negotiations of the combined bill are centered on the popular deductions for payments made for mortgage interest and state and local income taxes.
Currently, the cap on the mortgage interest deduction is $1 million. The bill would reduce that cap and allow homeowners to deduct interest only on the first $750,000 of a new mortgage. It’s important to note this applies only to new mortgages, not to mortgages already in existence prior to the law passing. With strong real estate markets and high prices in many major cities, this lower cap stands to affect the level of allowable deductions for many taxpayers.
Another big point of contention has been how to deal with state and local tax deductions. Currently, deductions for property tax, state income tax and sales taxes can be taken, subject to income limits imposed by the Pease limitation. The final bill allows deductions for all three taxes, but only up to $10,000. This new limitation is considered important for residents of high-tax states like New York, New Jersey and California. It also stands to affect high-income earners and those with larger home mortgages (both common in the greater D.C. region).
You may have heard debates about other common itemized deductions that lawmakers threatened to eliminate. These cuts drew criticism, and after some debate, were ultimately preserved. The common deductions that will still be allowed in 2018 include deductions for medical expenses, graduate school tuition waivers, teacher spending, student loan interest and private activity bonds.
One point that relates to these deduction changes is that the plan nearly doubles the standard deduction. It’s expected that the final plan will actually combine the personal exemption and standard deduction into one larger standard deduction totaling $12,000 for individuals and $24,000 for joint filers. Because about 70 percent of Americans claim the present standard deduction, the expectation is that paychecks may increase slightly if the tax plan is enacted. However, with this doubling of the total deduction, it’s likely that far fewer filers at all income levels will itemize their deductions, because the total of these deductions would need to exceed the new higher total deduction amount in order to qualify.
3. More flexibility in the use of 529 college savings plans
Parents with young or school-age children will be pleased to hear that the new bill provides increases in the ability to use 529 college savings plans to support your children’s K-12 education. Previously, 529 plans could be used only to cover costs for college. The new law expands the qualified use of 529 accounts by allowing withdrawals for public, private or religious schools. Home schooling families are also allowed to use 529 funds towards educational expenses. If you plan to take advantage of this expanded ruling, note the limit of $10,000 per year, per child.
The new legislation also supports funding of ABLE accounts designed for use by people with disabilities. Under the new law, you can roll over 529 plan assets to an ABLE account. Both accounts must have the same beneficiary or a member of the same family, and you can roll over up to the annual gift exclusion amount, which is $15,000 in 2018. Now families will have more flexibility in planning for special needs, where predicting the level of future needs can be a challenge.
While not new in this tax bill, higher-income earners may want to note that 529 plan contributions are not subject to any income limits. While other tax-advantaged savings accounts like IRAs and Roth IRAs restrict higher-income families from contributing, 529 plans can be used regardless of your income level. With the flexibility provided by the new law, parents not currently setting aside money for education may want to reconsider earmarking some savings toward a 529 plan.
4. Estate-planning-related taxes
Although initial tax plan discussions considered complete elimination of taxes on estates, the present plan keeps the federal estate tax in place, but it doubles the threshold at which that tax applies. It appears the need for utilizing trusts to protect against taxes at death will be less necessary if the final bill ends up phasing out estate tax by doubling the existing per-person exemption from $5.5 million to $11.2 million, and $22.4 million for married couples. Just like the present law, these exemptions also apply to lifetime and testamentary transfers.
How to respond
In general, the principles driving tax planning in prior years still apply. Most often, income should be deferred into next year and expense deductions pulled forward into this year. These tactics stand to provide even more benefit if the new tax law changes outlined above come to pass. That’s because income tax rates will be lower next year, and it’s likely there will be more limitations on expense deductions in 2018.
Some practical steps to take include deferring a year-end bonus into 2018, maximizing 401k plan contributions this year and reducing investment capital gains. If you’re self-employed, you probably can control both current year income and also accelerate business-related spending into 2017 to boost your deductions. Even retirees may be able to manage income by deferring until next year any unnecessary distributions from retirement accounts where distributions are generally taxed as ordinary income.
For those who previously had high itemized deductions or no mortgage, but relatively high charitable contributions, it may be worthwhile for your tax adviser to assess the potential impact of the changes to itemized deductions, as well as the potential effect of the increase in the standard deduction. One example involves taxpayers who have little to no mortgage interest write-off, but who make charitable contributions in excess of $10,000. In that case, there would be no benefit derived from incremental charitable contributions unless the total itemizable deductions exceed the new limits of $12,000 for an individual and $24,000 for a couple. This particular circumstance may create an opportunity to generate tax benefits by accelerating charitable gifting in 2017.
Depending on the size of contributions or intentions of the donor, utilizing a donor-advised fund may be advantageous.
One caution on estimating positive impacts of the bill: After 2025, many of the tax cuts for individuals are phased out. Of course, things can and probably will change in the meantime, including ways in which the government may decide to address the predicted addition to the federal deficit.
Finally, given the timing of these changes, there is little time to respond with year-end tax-based planning, so individuals may be left to respond after the first day of the year once the negotiations have ended and the final bill is passed.