There is more than a little speculation, and even more opinions, about the way changes to the tax code will impact individuals and businesses. This is a brief overview of some of the changes introduced by the Tax Cuts and Jobs Act of 2017, and how this legislation may impact financial planning decisions.
Federal Income Tax Changes
Most individuals and businesses will see at least a temporary reduction in their federal income tax over the next several years due to changes in deductions, credits and tax rates. While many aspects of the tax code have changed, your federal income tax is still calculated as follows:
Changes to Deductions
A deduction reduces the amount on which you are taxed. Its value depends on which tax bracket you are in; if you are in the 10% bracket a $1.00 deduction is worth $0.10, if you are in the 35% bracket, a $1.00 deduction is worth $0.35. Everyone is given at least one deduction (the standard deduction), which is a fixed dollar amount you subtract from your gross income. The new law increases the standard deduction to $12,000 per person ($24,000 per couple). People only itemize when their deductions add up to more than the standard deduction. In this example, Couple 1 would take the standard deduction, whereas Couple 2 would itemize. (For related reading, see: The 10 Most Overlooked Tax Deductions.)
Popular deductions for mortgage interest and state taxes survived the new legislation; however, for people like Couple 1 who will take the standard deduction, these expenses will not provide a tax benefit. Those who have previously itemized due to high state and real estate taxes are now faced with a $10,000 cap on state, local and real estate tax deductions. As illustrated in the Couple 2 Revised column, they too would now take the standard deduction because of this limit.
The shift from itemizing to taking the standard deduction requires a change in thinking for many of us. We can no longer assume charitable giving or mortgage interest results in an automatic tax break. They will only help us if our total deductions exceed the $12,000 or $24,000 standard deduction. Consequently, timing charitable giving and tax payments will be more important than ever.
Home Equity and Medical Expense Deductions
Interest deductions on home loans have new limits. Mortgages taken after December 15, 2017 will qualify for an interest deduction on up to $750,000 of debt (down from $1 million). Taxpayers who refinance older loans can still deduct interest on up to $1 million. Home-equity loan interest will only be deductible if it’s used to acquire, build or substantially improve your home. After 2017, there will be no more home equity deductions for money used for new cars, student loans or any other purposeso you should keep good records of how any home equity borrowing is used going forward if you plan on deducting it.
There is good news for those with high medical expenses in 2017 and 2018, as the threshold for deductibility was reduced from 10% of adjusted gross income to 7.5% for these two years only. Many will also be happy that the 3% reduction to itemized deductions for high-income taxpayers, the so-called Pease limitation, was repealed. On the down side, miscellaneous deductions were eliminated entirely, so write-offs for professional fees (attorneys, financial advisors, tax preparation) are gone. (For related reading, see: 20 Medical Expenses You Didn't Know You Could Deduct.)
Qualified Business Income
One of the most discussed deductions is the new qualified business income (QBI) deduction for pass-through entities (i.e. sole proprietors, independent contractors, partnerships, LLCs, S corporation shareholders). Such business owners were granted a 20% deduction on their income, effectively making $1.00 out of every $5.00 earned free of federal income tax. There are caps and limitations that apply, the most notable of which is an income phase-out for people in service industries such as law, finance, accounting, health, consulting, arts, athletics or any trade or business where the business is based on the reputation or skill of one or more of its employees. Said individuals will only qualify for the full QBI deduction if their taxable income is less than $157,500 for individuals and $315,000 for married couples. At $207,500 (or $415,000), the credit is entirely phased out. It’s expected that nearly all independent contractors will be classified as service businesses for the purposes of this deduction.
Tax Rates Decreased
As noted in Table 1, most of the seven individual tax rates have been reduced by a few percentage points. With our progressive tax system, you only move into a higher bracket by filling up the lower brackets first. It used to take $418,000 of taxable income for a single ($470,000 for a couple) before they reached the highest bracket. With the new law, the highest bracket will not kick in until $500,000 for individuals and $600,000 for couples. Capital gains tax rates remain unchanged at 0%, 15% and 20%, and the 3.8% net investment income tax remains in effect. While many in Congress wanted to ax the alternative minimum tax (AMT) for individuals, it survived. Fortunately, the AMT should affect far fewer taxpayers going forward due to changes around the AMT exemption and phaseout amounts. For C corporations, the top tax rate is now 21% (down from 35%) and the corporate AMT was eliminated altogether.
Changes to Tax Credits
The personal exemption, a $4,050 deduction for each member of your household, was eliminated. This change disadvantages families with multiple children. To lessen the blow, changes were made to the child tax credit. Unlike a deduction, which reduces the total amount on which you are taxed, a credit is a dollar-for-dollar reduction in the tax you owe. The child tax credit was doubled to $2,000 per dependent child under 17 and the phaseout for the credit was changed so that more high-income families will now be able to claim this credit. For children up to 23 in college and other dependents such as aging parents, a new $500 credit replaces the personal exemption.
Other Notable Provisions
The home sale exclusion, which excludes capital gains on up to $250,000 per individual ($500,000 per couple), was not changed in the new law. Roth conversions will no longer be eligible for recharacterization, meaning you can’t undo a Roth conversion the following year, as you could in the past. Qualified tuition plans, commonly known as 529 plans, have been modified to allow tax-free distributions of up to $10,000 per year per student for primary and secondary education. Distributions can be used to pay for expenses for public, private, religious or home schools. The estate tax remains in effect at 40% of taxable estates; however, the estate tax exemption was doubled to $11.2 million per individual ($22.4 million for couples). The number of estates hit with the estate tax was already very limited but will now be even lower.
The Future of Tax Law
All the corporate changes in the bill have been made permanent, as is a deceptively minor change to the way tax brackets are increased for inflation. The new chained-CPI inflation adjustment is likely to result in smaller adjustments to the tax bracket breakpoints, meaning more income will be taxed at higher rates as time goes on. That could prove especially painful when the individual tax rules sunset and revert to prior law. Unless a future Congress extends the changes, the lapse of these tax breaks combined with smaller tax bracket adjustments would likely mean higher taxes for individuals starting in 2026.
(For more from this author, see: Don't Let Today Guy Destroy Your Financial Future.)