Monday was the official opening of the tax filing season. The next few weeks may seem like the normal hustle and bustle of gathering documents for your CPA. However, the tax-filing process is actually very different this year. Effective in 2018, the Tax Cuts and Jobs Act (TCJA) doubled the standard deduction, eliminated the personal exemption, and wiped out several popular deductions that millions of taxpayers utilized previously. Here are a few key changes to keep in mind.
Standard Deduction & Personal Exemptions
Annually, taxpayers decide whether they will take the standard deduction on their tax return, or if they have enough itemized deductions to claim a greater offset against taxable income. In an effort to create a “simpler” tax return, the TCJA doubled the standard deduction from $6,350 to $12,000 for individuals, and from $12,700 to $24,000 for married couples[i].
At the same time, in the spirit of “simplicity” the TCJA eliminated the personal exemptions and dependent exemptions of $4,050 per person. Prior to 2018, taxpayers could claim a personal exemption for themselves and a dependent exemption for each eligible dependent.
Here is a very basic example[ii]. Say you’re a married couple with two dependent children. Prior to the new tax law, you have itemized expenses totaling $15,000. Your itemized deductions are higher than the $12,700 standard deduction, so you opt to itemize. You are also eligible for 4 exemptions of $4,050 for you, your spouse, and your two dependent children. Therefore, you have a total benefit of approximately $31,200. However, with the new TCJA, this same couple would be urged to take the standard deduction of $24,000 in lieu of the $15,000 of itemized expenses they incurred during the year. Given personal deductions are no longer allowed, their total tax deduction is $24,000, which compared to the old rules would result in a loss of $7,200 in benefits.
Other Eliminated Deductions and Changes
One of the notable changes in the Tax Cuts and Jobs Act (TCJA) was the reduction of the corporate tax rate from 35% down to 20%. During the first three quarters of 2018, large US companies earned profits of about 25% over the prior year due greatly to the tax benefit[iii]. However, to make up for the big corporate tax breaks, many of the personal deductions by individual taxpayers were eliminated. Some of the eliminated deductions include the following[iv][v]:
- Home Mortgage Interest – You can no longer deduct the interest paid on debt over $750,000 to acquire a home. With the median home price in Los Angeles County near $1 million[vi], this rule will likely affect many living in metropolitan areas of the country.
- Home Equity Loan Interest – Interest on home equity loans or HELOCs are no longer deductible if the proceeds are utilized for something other than home improvements (I.e.: if you used the HELOC to pay off credit card debt or pay for your child’s college tuition). If the loan proceeds are used for home improvements, the interest would be deductible only if the combined debt of the primary home loan and the HELOC are below the $750,000 cap under the new tax law. Homeowners with existing mortgages and home equity lines will be grandfathered in and therefore unaffected by the new law.
- Job Expenses – Many hard-working employees, such as teachers, pay for a great deal of job-related expenses out of pocket (i.e.: supplies, union dues, work-related education, home-office expenses, tools, work clothes, etc.). Prior to the TCJA, these used to be deductible on your tax return if the total of your miscellaneous expense exceeded 2% of your AGI.
- Tax Preparation Fees – This item was also a tax deduction if in combination with other miscellaneous expenses, exceeded 2% of your AGI.
- Miscellaneous Deductions – Items in this category included investment advisory and management fees, fees for legal and tax advice related to investments, trustee fees, etc. These were also subject to the 2% of AGI rule.
Charitable Gifting Solutions
It is estimated that due to the higher standard deduction in the Tax Cuts and Jobs Act, the number of people who make tax deductible charitable gifts will drop by 50%[vii]. That’s because with the standard deduction doubling, few will have the means to gift in excess of the $12,000 and $24,000 limits for single or joint filers, respectively. As a result, Qualified Charitable Distributions (QCDs) have elevated in popularity and a new strategy called bunching has emerged.
Qualified Charitable Distributions (QCDs) allow a retiree age 70.5 or older to donate their Required Minimum Distribution (RMD) directly to a qualified charitable organization. The QCD avoids the pitfalls of the new higher standard deduction because the QCD is a direct reduction of taxable income rather than a tax-deductible item that needs to exceed your standard deduction threshold.
Bunching is the strategy of combining several years of gifts into one larger gift in a single year that will qualify for a tax deduction. Some employ this strategy utilizing a Donor Advised Fund (DAF); a charitable gifting vehicle which makes gifts on behalf of an organization or family. Your financial planner can help you determine if these strategies make sense for you and aid you in completing the transaction if so.
Hopefully the new tax laws will work in your favor. Tax efficient strategies of investing, saving and gifting often come about when your professionals work together collaboratively. Be sure that your investment advisor and CPA are communicating throughout the year to create a customized plan that helps you achieve your goals and manage your tax liability.
[ii] There are many variables that could affect the outcome of this example and all individual estimates of tax should be prepared by a qualified tax professional.
[vii] WSJ: Charitable Contributions by Laura Saunders 2/14/18