Focusing on the Fundamentals of the Tax Cuts and Jobs Act of 2017
By now it is not breaking news that we have, starting in 2018, a new (well, newish) federal tax law. It would however be instructive to consider the changes that will most directly impact the bulk of our clients. To our way of thinking they are as follows:
Income Tax; Personal Exemptions, Deductions, and Rates. There were some significant changes to these core areas of the tax code. The changes to personal exemptions, the standard deduction, and individual rates are all temporary; they apply to tax years 2018 through 2026.
Personal Exemptions Eliminated – Through 2017, a taxpayer not claimed as a dependent on another person's return may claim a personal exemption of $4,050 per person. An exemption is just that – an amount of income that is not taxed. These personal exemptions have been eliminated for 2018 through 2026.
Increased Standard Deduction – A deduction is an amount subtracted from a taxpayer's income before the tax is calculated; deductions reduce the amount of income taxed. For 2017, single filers may claim a standard deduction of $6,350 and married taxpayers filing jointly may claim a standard deduction of $12,700. Taxpayers typically choose to itemize deductions if their itemized deductions total more than the standard deduction. A bigger deduction results in less taxable income and, therefore, less tax.
Under the new law, the standard deduction increases substantially to $12,000 for single filers and $24,000 for joint filers. This increased standard deduction is in place for 2018 through 2026, with indexed increases, and will result in fewer taxpayers choosing to itemize deductions.
Tax rates – The new law also made temporary changes (through 2026) to the tax rates by reducing the number of brackets and decreasing the rates themselves. For example, married taxpayers filing jointly for 2018 pay:
10% on the first $19,050
12% on $19,051 to $77,400,
22% on $77,401 to $165,000
24% on $165,001 to $315,000
32% on $315,001 to $400,000
35% on $400,001 to $600,000
37% on $600,001+
These rates are a collective decrease from what they would have been under existing law:
10% on the first $19,050
15% on $19,051 to 77,400
25% on $77,401 to $156,150
28% on $156,151 to $237,950
33% on $237,951 to $424,950
35% on $424,951 to $480,050
39.6% on $480,051+
The numbers speak for themselves. Through 2026, the increased standard deduction combined with the lower rates will result in a decrease in taxes, most significantly for higher earners.
Qualified business income – Any thoughts you may have had that the Tax Cuts and Jobs Act would simplify the tax code can be immediately dispelled by looking into the rules surrounding the new 20% deduction for qualified business income from pass-through entities. For purposes of this piece, it is sufficient to say that if you operate a small business, you should consult with your attorney and/or CPA to determine whether you might be able to take advantage of this deduction. It can be valuable, but is subject to several limitations.
Capital gain - While you may not need to concern yourself with Estate taxes or Gift taxes, you need to remember that it is still the law that if you give a child stock tomorrow that you bought in 1973 for $2,000.00 that is now worth $15,000.00, your child has a cost-basis in the asset of $2,000.00. When he or she sells it, his/her long-term capital gain taxed at 15% or 20% (depending upon bracket) will be measured from that basis. If, on the other hand, you wait to give the stock to your child upon your death, he/she will have a step-up cost basis measured as of your date of death. Translate that probably into less gain and less tax. The step-up in basis is going to become an even more important aspect of estate planning than it was, considering it is spread between the Capital Gain taxes of 15%-20% (depending upon bracket) versus Estate taxes, if they would ever be payable, of 40%.
Medical expense deduction - Though originally slated for elimination, the medical expense deduction survived tax reform and came out stronger than before – temporarily. Prior to tax reform, taxpayers could claim an itemized deduction for medical expenses exceeding 10% of adjusted gross income (7.5% of AGI for taxpayers 65 and over). The new law retains this itemized deduction for medical expenses in excess of 7.5% of AGI for all taxpayers regardless of age for 2017 and 2018. Beginning in 2019, only expenses in excess of 10% of AGI will be deductible for all taxpayers. Qualifying medical expenses include doctor visits, lab work, health insurance premiums, travel (actual expenses or $0.17 per mile), home care and assisted living care (including meals and lodging costs if there for medical treatment). See IRS Publication 502 for more information. Practically speaking, the increase in the standard deduction will most likely result in fewer people itemizing medical expenses; however, this deduction remains particularly valuable for those with chronic illness and high medical costs.
Student loan interest deduction - Though some proposals would have eliminated it, the deduction for student loan interest survives. Taxpayers who pay interest on a qualifying student loan can deduct up to $2,500 of that interest from their income. This deduction is "above the line," making it more valuable than an itemized deduction because it reduces adjusted gross income. To qualify, the loan must have been taken out for the qualifying educational expenses of the taxpayer, spouse, or person who was a dependent at the time of the loan. The taxpayer must be legally obligated to pay the interest and must have actually paid the interest. The deduction begins to phase out for single filers with Modified Adjusted Gross Income of $65,000 ($135,000 for married filing jointly) or more. For more information, see IRS Publication 970.
Estate, Gift, and GST Tax. Big changes in these areas . . . for now. As you consider the following, remember if you are going to live long enough to be alive in 2026, then once again, as in 2011, the tax breaks afforded by the 2017 Tax Act will expire.
Increased exemptions - The exemption amount for Federal Gift Tax, Estate Tax and Generation Skipping Transfer tax is $11,200,000.00 per person. So, if you are comfortably below that and have not used up a lot of your exemption previously, you probably do not need to worry about these taxes until you win the Powerball (about which, see us promptly). As before, Michigan does not have an estate tax or inheritance tax so you do not need to worry about that.
Annual exclusion gifts -The annual per-donee present interest gift tax exclusion is currently $15,000.00. Thus, you and your spouse, if so inclined, could give to each of your children $30,000.00 without reporting to the IRS.
Trust considerations - Thinking about current Trusts; you and your spouse may have Trusts which were drafted at a time when the Estate tax exemption was remarkably lower. It was, for example, $2,000,000.00 in 2008. A plan as of that time was designed to capture the amount that could be exempted from the Federal Estate within what is known as an Exempt Trust (a/k/a the Family Trust) and passing the rest of the property to the surviving spouse in some fashion that would make use of the marital deduction and thus, avoid the tax to the first to die and have the assets that were in the Marital Trust taxed in the estate of the surviving spouse. It may now be appropriate to consider rethinking your planning.
If the ONLY reason you were using the Exempt Trust type format was to save on taxes, and there are no taxes to be saved because of the joint exemption rate, you really can make your Trusts substantially simpler to administer. Your old Trust will be no doubt irrevocable upon your death, which is not the time for your surviving spouse to be wishing that the planning documents had been changed.