Most of us have been watching the twists and turns of the recently signed Tax Act with bated breath—what Senators will hold out, which last-minute provisions will sneak in, and most important of all, how will the law affect us, our clients, and the American public?
Well the waiting is done and I have spent most of the New Year’s Weekend reading the bill. There are still several things we need to understand like how the elimination of deductions, compression of tax rates, and brand-new benefits for certain taxpayers will affect all of us. According to the Tax Policy Center, four out of every five taxpayers can expect a reduction. How big a reduction will depend on many factors and many lower income tax payers will notice only a small decrease while people living in high property and state income tax areas will likely see an increase.
Every taxpayer will need to assess their individual situation. But in the meantime, here are some initial thoughts and areas I found interesting. Of course, any advice below is subject to your specific tax situation, with consideration to your state of residence and AMT, among other things.
Less SALT more taxes
For many people the acronym SALT (State and Local tax) was a new one. 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. As a result we may see a reduction in property values in those states as the markets adjust to the changes in the tax law.
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 more tax-friendly states such as Texas, Tennessee, Arizona, or Florida.
Goodbye to miscellaneous itemized deductions
The elimination of the deductibility of miscellaneous itemized deductions for tax preparation fees, investment fees (sadly) , moving expenses, and employee expenses (really sad for many employees) means we should reconsider how and when we pay expenses. If you are a regular user of the employee expense or moving expense deductions you should discuss with your employer if they would now be able to reimburse you for those expenses. If you are paying for the management fees to your financial advisor for your retirement (IRA) assets from outside funds you should strongly consider paying for them directly through your IRA.
The Charitable Impact
Due to the expansion of the standard deduction to $24,000 per couple, it is likely that fewer people will itemize deductions going forward thus reducing or eliminating the charitable deduction for many people. 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. And speaking of charitable contributions, people have a tendency to write checks to charity, but more and more we want to encourage 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 you own 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 Roths
You will need to be 100% sure if you decide to do a Roth conversion because there is no longer any way to undo it. 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. Having said that, we still highly recommend the Roth conversions, so this may simply entail doing smaller conversions over a longer period of time, so that you aren’t 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.
No Alimony Deduction For You!
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. 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.
Chipping away at the estate tax problem
With the expansion of the estate tax exemption to $11.2 million per couple, those who have already used their estate exemption in prior years would be able to make additional tax-free gifts in 2018. Thus, every advisor should be reviewing their client list to determine which client’s estates were valued at or exceeding the prior lifetime exemption to determine what additional planning should be in place to decrease estate taxes.
Still Not Simple Enough
Although the Tax Act was publicized as a way to simplify taxes, it will be anything but. It is going to require continued consultation with tax professionals and significant creativity and understanding with the new wrinkles that have been added especially with SALT and businesses.
If you want to discuss this further we suggest you call us or your tax professional to make sure you update your tax planning strategies.