Like just about everything these days, most of the coverage around the “Tax Cuts and Jobs Act” has been viewed with an overwhelmingly partisan lens. Most of this has to do with the nature of the corporate tax cuts in the law, perhaps justifiably so. But in my opinion, there’s been far too little discussion about the actual impact the law will have on individuals and families in our generation.
Now that the political bickering is over (at least on this issue…) and the tax proposal has been finalized, let’s take a look at exactly how this tax overhaul will affect you. This is a mammoth piece of legislation, so I won’t be able to cover every detail, but we will cover the major pieces.
One note: all of these changes apply to the 2018 tax year, with two major exceptions. Your 2017 taxes, due April 15, 2018, will be unaffected unless you are itemizing medical expense deductions. And, the Individual Mandate repeal doesn’t kick in until 2019.
That being said, the change in tax law has created some unique opportunities to save on taxes, both in 2017 and beyond.
[Note: the day after Congress passed the Tax Cuts and Jobs Act in December 2017, I hosted a Facebook Live chat summarizing the provisions of the bill. The video is available below.]
What’s NOT in the Law?
Before we dive into exactly what the new tax code says, we need to quickly talk about what it doesn’t say. There were several controversial elements inside the draft bill that got a lot of media attention. Several of these were stripped out of the final version- you no longer have to worry about any of these rumored changes. These include:
- The provision that would have treated graduate student tuition waivers as taxable income is gone from the final version of the law. This would have increased taxes on graduate students by as much as 400%, but it was removed from the final law.
- At one time, there was a proposal to remove the ability to deduct student loan interest payments from your taxable income. This provision was removed as well. You can still deduct the amount you pay in interest toward your student loans, up to $2,500 in interest per year.
- There was also a provision that would have caused tuition payments made by your employer to be fully taxable to you. This was also removed- your employer can give you $5,250 tax-free for tuition, which is unchanged from the old tax law.
Tax Rate Changes
Now, let’s talk through the major changes that have been introduced, starting with tax rates themselves.
- For most Americans, your marginal tax rates will be going down (albeit temporarily- these cuts expire in 2025, although Congress may extend them). Find your income level in the tables below to see how your tax rates compare in the old and new tax code.
- A few key items to note:
- While most people will see a decrease in their tax rate, there’s one group of people who will see an increase: unmarried people who have a yearly taxable income roughly between $157,000 and $416,000. The logic behind drawing the boundaries of the tax rates in this way is unclear.
- There are also some income ranges, both for individual and married taxpayers, where there is no change in the marginal rate. For example, a married couple with $450,000 in annual income is in the 35% tax bracket in the old tax code, and the 35% tax bracket in the new tax code. (Although, it is worth noting that even though the marginal tax brackets are unchanged, the total taxes owed is less due to the decreased marginal brackets below the 35% bracket.)
- There’s a distortion in the tax code if you are married and both you and your spouse make a high income, frequently called the “Marriage Penalty”. For example, let’s say you and your spouse make $400,000 each. If you were filing individually, you each would fall in the 35% tax bracket. However, if you’re married filing jointly, you have $800,000 in taxable income as a household, which puts you in the 37% tax bracket.
- Taxes on investment income (dividends and long-term capital gains) have not changed under the new tax law. Depending on your income, you’ll either pay 0%, 15%, or 20% in taxes on dividends or capital gains.
Personal Income Tax Reductions and Pass Through Businesses
- There’s one other change in how income is taxed, and it’s a big one. The change relates to “pass through” businesses, which are businesses that don’t pay corporate income taxes, but instead “pass through” their earnings to individuals who pay the tax at their individual tax rates. Under the new law, these “pass through” businesses are allowed to deduct 20% of their income (or 50% of the wages they pay, whichever is less) from their total taxable income. In plain English, if a pass through business makes $100,000 in income, they are allowed to reduce their taxable income by 20%- meaning that the individual who gets the pass through income only pays taxes on $80,000 worth of income.
- This is a bigger deal for you than you may realize. A pass through business doesn’t have to be a big company; in fact, more often than not these businesses are really just individuals who are self-employed. For example, independent contractors and sole proprietors are typically set up as pass through businesses. Which means that if you and a friend do the same exact job, but you are an employee of a big firm and your friend is an independent contractor, your friend will pay taxes on 20% less income than you. This likely to accelerate the growing trend of workers becoming independent contractors rather than full-time employees– there’s now a clear tax benefit to doing so.
- But, there’s a catch. Pass through businesses that engage in a “service-based” business have some restrictions on how much you can make to qualify for the 20% deduction. If your pass through business income is more than $157,500 for individuals (or $315,000 for married couples), your ability to deduct 20% of your taxable income starts to phase out.
- What counts as a “service-based business”? Most occupations that involve selling a service to another person, including accounting, health, law, financial services, and consulting. Oddly enough, two services were specifically excluded from the income phaseouts: engineers and architects. If you work in either of these fields, your income can grow as much as you’d like without losing the ability to deduct 20%.
Standard Deductions and Personal Exemptions
The income-component to the tax code change is relatively straightforward: most people will have a reduction in their overall tax rate, except for the specific groups I outlined about. However, this only tells part of the story.
Note: It’s a little bit more complicated to tell if these changes will be a net benefit or net loss for you, as they tend to offset each other. I’m going to lay out the changes and give you the tools you need to get an idea whether this will have a net positive or net negative impact on you, but it’s always a good idea to talk to a CPA about your unique circumstances.
- Once you calculate how much you have in taxable income, you are allowed to either deduct a variety of expenditures from your taxable income (we’ll get to that in a minute), or take what’s called a Standard Deduction. The standard deduction directly reduces your taxable income. Under the old law, individuals could claim a $6,350 standard deduction, and married couples could claim a $12,700 standard deduction. Under the new law, the standard deductions have nearly doubled. Now, individuals can reduce $12,000 and couples can reduce $24,000 in taxable income under the new standard deduction.
Clearly, this is a net benefit, right? Sort of.
- Under the old tax code, you also had the ability to claim a personal exemption of $4,050 for yourself ($8,100 for a married couple), and another $4,050 exemption for each child that you have. These exemptions, like the standard deduction, reduce your taxable income. Under the new tax law, these exemptions have been eliminated
It’s critical to note that the amount of the personal exemption being removed ($4,050) is less than the increase in the standard deduction (a $5,650 increase for individuals and a $11,300 increase for couples). So, for people without children, this is a net win. But, particularly for large families who claimed the $4,050 exemption for each child, your taxable income is going up considerably. However…
- There are two changes to the Child Tax Credit under the new law that likely will more than make up for the loss of the exemptions for families with children:
- The amount of the tax credit has doubled, from $1,000 to $2,000 per child, per year. Note that, unlike the discussion around exemptions and deductions (that referred to taxable income), the $2,000 tax credit is literally a $2,000 reduction in the taxes that you owe. Which makes it a considerably better benefit than a $4,050 reduction in taxable income. One other note: if your final tax calculation comes out that you don’t owe any money in taxes, $1,400 of the $2,000 credit is refundable to you.
- There are income restrictions for who is eligible for the Child Tax Credit, but these have been greatly expanded under the new law to make the credits more accessible to more families. Now, individuals who make less than $200,000 per year or married couples who make less than $400,000 per year can claim this credit.
As an example, let’s look at a household that consists of a husband, wife, and three children. Both the husband and wife make $175,000 each.
Even though they have a greater taxable income under the old tax code, they save over $18,000 in taxes, both because of the decrease in marginal tax rate and the substantial Child Tax Credit.
To summarize: your standard deduction has gotten better, your ability to claim exemptions has been removed/gotten worse (particularly for large families), and the expansion of the Child Tax Credit has gotten significantly better for families with children under certain income thresholds.
LOTS of Changes in Itemized Deductions
As I mentioned above, everyone can claim the standard deduction. But, if you can list a set of qualified expenses that exceed the amount of the standard deduction, you are still allowed to use the itemized deduction process. It wasn’t common to itemize deductions before, and now that the standard deduction has been doubled, it will be even less common now (since you need to have nearly double the amount of expenditures in order to be better off itemizing). But, if you do itemize, here’s what you need to know about the changes to the types of expenses that qualify for itemization:
- Charitable Contributions- There were a lot of rumors that we would be losing the ability to deduct charitable contributions under this law. That fear proved to be unfounded: the amount you can itemize for charitable contributions has actually increased (from 50% to 60%). But, of course, fewer people will take advantage of this now that the threshold to exceed the standard deduction has nearly doubled.
- Mortgage Interest– There are two big changes here:
- You are still able to deduct the amount of interest paid on a mortgage, but the amount of interest that qualifies has been reduced. Before, you could deduct interest paid on the first $1,000,000 of mortgage principal; this has now been reduced to $750,000. But, it’s critical to note that all mortgages in existence before December 15, 2017 have been grandfathered in and are not subject to the new rules.
- Interest paid on Home Equity Loans or Home Equity Lines of Credit is no longer deductible.
- State and Local Taxes– this one has gotten a lot of press coverage. Before, you were able to deduct the amount you pay in state taxes and local taxes on your federal tax return. There was a lot of talk about removing this provision entirely, but in the end, the final tax law merely put restrictions on this ability rather than eliminating it altogether. You are now able to deduct a maximum of $10,000 in state and local taxes, rather than unlimited amount. This particularly hurts high-income individuals in states and cities with high tax rates.
- Your ability to deduct medical expenses has temporarily expanded, even though this was another item that Congress nearly eliminated. If you have medical expenses that exceed 7.5% of your income, you can deduct these expenses in 2017 and 2018, which is down from a 10% of income threshold. But, in 2019, the ability to deduct medical expenses goes back to 10% of income. One other note: this is, I believe, the only change that applies to your 2017 income taxes (that are due April 15, 2018).
- The IRS had a long list of Miscellaneous Expenses that could be deducted if they exceed 2% of your taxable income. Most commonly, the ability to deduct expenses relating to tax preparation fell under this category. The ability to make these deductions has now been eliminated.
- You are no longer allowed to deduct moving expenses. (With one exception: you are still allowed to deduct moving expenses if you’re in the military and you are required to move for a military job).
- Finally, alimony payments are no longer treated as a taxable transfer. Under the old rules, the person who pays alimony to an ex-spouse was allowed to deduct the alimony amount, and the person who received the alimony payment needed to count it as taxable income. This is no longer the case, but similar to the grandfathering under the mortgage interest deduction, the new rules only apply to new or modified alimony agreements in 2018 and beyond.
Other Big Changes
There are a few other big changes to the tax code that don’t relate to the tax rates or various deductions available:
- The Individual Mandate that requires you to pay taxes if you don’t have health insurance under the Affordable Care Act (“Obamacare”) hasn’t technically been repealed…. But the taxable penalty for not having health insurance is $0, starting in 2019. This doesn’t mean that you shouldn’t have health insurance (you should), but it does mean that you won’t be taxed if you don’t have health coverage. But again, note that this provision starts in 2019. If you don’t have health insurance in 2017 or 2018, you’ll still need to pay the tax.
- There are several changes to the use of 529 Accounts. Historically, these accounts have been one of the most tax-advantaged accounts to save for college- contributions are tax free at the federal level and can be tax free at the state level as well, and withdrawals are tax free if used for qualified higher education expenses. Under the new code, they now can also be used to fund K-12 education expenses- they’re not just for college savings anymore. Under the new rules, you’re allowed to withdraw $10,000, per child, per year, for qualifying K-12 education expenses (including private school tuition). There was a provision in the bill that would have extended these accounts to be able to be used for homeschooling education expenses, but this was removed from the final version of the law. 529’s can now be used for college expenses and K-12 expenses, but not homeschooling.
- There are two other huge changes that are much less likely to affect younger people, so I’m going to gloss over them. But you should be aware that they exist:
- The Alternative Minimum Tax (AMT) is still around, but it’s now much harder to actually qualify to pay the AMT. The AMT is a method of making sure that very rich people can’t use too many loopholes to avoid paying taxes. Essentially, under the AMT, you need to calculate the amount of taxes you owe twice– once under the standard tax rules, and once under the AMT rules. If you owe more in AMT taxes, you need to pay the AMT. This is still in existence, but it’s going to be much harder for people to actually need to pay the AMT. If you have a very high income, this is something to keep on your radar, but most people don’t need to worry about this at this time.
- The Estate Tax, like the AMT, is still around, but almost nobody will qualify for it anymore. The estate tax is a vehicle used to tax the amount of wealth someone has after they die, before the wealth is inherited by the next generation. The estate tax still exists, but your estate needs to be double the size it used to be in order to be subject to the estate tax. Until you have $11.2 million dollars saved up (or $22.4 million for couples), you don’t need to worry about it!
When they began the tax reform process in early 2017, Republican leaders in Congress claimed that they wanted to make it so easy to file your taxes that most Americans would be able to file taxes on a postcard. As you can probably tell from the summary above, they fell… just a little short of that goal.
That being said, the fact remains that for most taxpayers, the filing process will be somewhat expedited, primarily by doubling the standard deduction. For many people, you’ll just need to calculate your taxable income, take your standard deduction (and, potentially, your Child Tax Credit), and you’ll be good to go.
What do you think? How will the new tax law affect the amount of taxes you pay?