Year-End Tax Tips, in Light of Tax Reform
The end of the year is traditionally a good time to tackle tax planning. You have an idea of what your total income will be, so you can make decisions with an eye on tax efficiencies.
This year, the back-and-forth on tax reform has narrowed the window of opportunity a bit. The House and the Senate have finally agreed on a final version of tax reform legislation (click here for a summary). However, it is not law yet. The House voted today to pass it, and the Senate is scheduled to vote tonight. While some uncertainty remains, there are a number of actions you can take before 2017 wraps up to save tax dollars. Below are several strategies with limited downside risk should the bill fail to become law.
**Note: Please talk to your advisor as soon as possible if you would like to pursue any of these strategies. Some require paperwork and may be subject to custodian deadlines.
1. Prepay state and local income and property tax in 2017.
(IF you’re not subject to AMT)
Because these deductions are limited in 2018 ($10,000 cap), it’s best to accelerate payment if you can. However, if you expect to pay Alternative Minimum Tax (AMT) in 2017, you lose the benefit of the deduction for state and local taxes and accelerated payments will not provide a benefit. When it comes to prepaying state and local income taxes keep in mind that you can only deduct amounts related to 2017 tax liabilities. This limitation on prepayment of taxes does not apply to property taxes.
Update as of 12/27/17:
The IRS clarified today the ability to deduct 2018 property taxes paid in 2017. To be deductible, the taxes must be assessed by the local tax jurisdiction and paid in 2017. So, if your city or county has not yet sent you an assessment of your 2018 property taxes, you cannot estimate them, pay that amount in 2017 and take a related deduction. Some localities have made special early assessments to allow their residents to pay early. However, at this point, this is the exception and not the rule.
2. Accelerate income into 2017 so you can prepay related state income tax now.
(IF your taxable income exceeds $500,000 [single] or $600,000 [married filing jointly and not in AMT])
You may consider accelerating income you might otherwise recognize in 2018—including options, capital gains, etc.—into this year. If you’re in a state with high income tax rates (>6%), and you’re not in AMT for 2017, the ability to deduct the related state income taxes on the accelerated income would outweigh the reduced top bracket in 2018 (39.6% v 37%).
3. Consider the timing of other itemized deductions besides state and local taxes.
Under current law you have the option to itemize your deductions (state income taxes, real estate taxes, charitable contributions, etc.) or take the standard deduction. Whichever is higher. In 2017 the standard deduction for single filers is $6,350 and $12,700 for married filers. Under the proposed bill, these amounts would increase to $12,000 and $24,000, respectively. The increase to the standard deduction, and the limitation/elimination of some itemized deductions, will significantly decrease the number of taxpayers that itemize their deductions.
If you think your 2018 itemized deductions will not exceed the new standard deduction, consider paying those items early. Due to the proposed limitation on state and local taxes, I may not itemize my deductions next year. So, my wife and I decided to accelerate a donation we planned to make in March 2018 into December of this year. This guaranteed we would receive a benefit from the deduction. The same thought process applies to any other expense you can currently itemize (medical expenses above AGI floor, etc.)
4. Consider a 529 plan contribution.
(Especially beneficial if you send your children to private school)
The new tax plan extends 529 plans to apply to K-12 (up to $10,000 annually), as well as post-secondary education (unlimited), but you can’t take a distribution for K-12 expenses until next year. If your state allows an income tax deduction for 529 contributions, and you have not already maxed out that deduction, you might consider funding an existing plan—or quickly opening one—before the end of the year. That way, you can make K-12 tuition payments in 2018 with those contributed dollars.
Pay attention to the tax law in your state for deductions related to 529 contributions. There is generally a limit on how much you can deduct in one tax year. In Missouri the deduction is limited to $8,000 per individual taxpayer or $16,000 for a married couple. Many states, like Missouri, allow you to deduct contributions to any 529 plan. Other states, like Illinois, only allow deductions for contributions to that state’s plan. Still others, like California, do not allow a deduction at all.
A final note … 529 plan contributions are subject to gift tax rules. Contributions do qualify for the gift tax annual exclusion amount ($14,000 per done in 2017). You should consider whether you have made other gifts to the 529 plan beneficiary before making a 529 plan contribution.
5. Business owners: Consider placing qualified business property into service in 2017 vs. 2018.
As a business owner, you can fully take advantage of the new 100% expensing of qualified business property (“modified bonus depreciation”) in 2018 through 2022. However, you may realize an even greater benefit for a deduction in 2017, since the tax rates under current law are generally higher than the new tax rates which will apply beginning in 2018.
As a result of tax reform, the tax rates will generally decrease for taxpayers and a 20% deduction will be allowed against “Qualified Business Income”. The 100% expensing of qualified business property provision is one of the few that was made retroactive (applies to property placed into service after September 27, 2017) and applies to both new and used qualified business property.
Other Implications to Note
- Tax Lot Identification
- Earlier versions of the proposed bill included a requirement to use First-in First-out accounting when selecting tax lots of securities that were sold. This would require you to sell your oldest tax lots (most likely to have higher built in gains) first. Luckily this provision was removed from the final version of the proposed bill.
- $10,000 State & Local Tax Deduction Cap:
- Individuals and married couples filing jointly are subject to the same $10,000 deduction limit on state and local taxes. Often limits for joint filers are double those of individual filers. So, this is a bit of a “marriage penalty.” This is a combined limit covering all state and local taxes (income, property, sales, etc.)
- Expanded Medical Deduction for 2017 & 2018
- Under current law medical expenses are allowed as an itemized deduction to the extent they exceed 10% of AGI. Under the proposed law, the threshold goes down to 7.5% of AGI. This change is effective for the 2017 tax year but reverts back to the 10% threshold in 2019.
- Miscellaneous Itemized Deductions:
- Many fees—including those for tax prep, tax-related legal counsel, unreimbursed business expenses, safety deposit boxes, professional dues and financial advice— were previously deductible to the extent they exceeded 2% of AGI. The proposed bill eliminates these deductions. So, paying Plancorp’s fees with pre-tax dollars (e.g., through your IRA) on a go forward would make sense. Keep in mind that an IRA can only pay investment advisory fees related to the management of IRA assets. It cannot pay fees related to a taxable account. It will still make sense to pay fees on a Roth IRA (after-tax dollars) from a taxable account.
- Mortgage Interest Changes:
- Before, you could deduct mortgage interest on up to $1 million plus $100,000 of home equity loans on your primary residence. The new bill eliminates the home equity piece completely and decreases the $1 million mortgage limit to $750,000. However, it is not limited to debt on your primary residence. If you enter a contract to buy a new house from last Friday forward, these new rules apply to you.
- Alternative Minimum Tax Changes:
- The proposed bill does not eliminate the Alternative Minimum Tax but the related exemptions and phaseouts were increased. Individuals would have an exemption of $70,300 that is phased out beginning at $500,000 of income (AMTI). For married couples filing jointly the exemption is $109,400 and the phaseout begins at $1,000,000 of income (AMTI). The higher exemptions/phaseouts, the limitation on deducting state/local taxes and the elimination of miscellaneous itemized deductions should significantly reduce the number of individual taxpayers paying AMT in the future.
- Roth Conversions:
- The proposed bill eliminates your ability to recharacterize or undo a Roth conversion. Recharacterization provides a significant benefit if the value of a Roth IRA declines substantially post conversion. The loss of the ability to recharacterize limits your ability to optimize Roth conversion strategies. That being said, Roth conversions remain a valuable wealth-building tool.
- Business Implications:
- Under the proposed law, choosing an entity (e.g. C corp, pass-through, etc.) for your business would become more nuanced than it is today. Pass-through entities have been the dominant choice for some time but that could change going forward. We’ll address these considerations in further detail in the coming months.
- Increased Estate/Gift Tax & Generation Skipping Tax Exemptions
- While the estate and generation skipping taxes are not repealed under the proposed law, the exemption amounts have doubled to $10 million per taxpayer adjusted for inflation ($11.2 million in 2018). For those taxpayers that have used their existing exemptions this presents an additional planning opportunity.
- Sunset Provisions:
- Other than corporate tax reform, the repeal of the individual mandate, and a few other administrative changes, the rest of the proposed tax bill expires or “sunsets” at the end of 2025. At that point individual taxes will revert back to current law. This is similar to President Bush’s tax cuts in 2001 and 2003. Those cuts eventually became “permanent”. Whether or not the sunset occurs in 2025 or the proposed law is made permanent is anyone’s guess at this point. However, it ensures that tax reform will be an annual topic in Washington D.C. for the next 8 years.
- This was supposed to be a major objective of tax reform. One could argue the proposed bill achieves this objective for corporations and some individuals. You could also argue it increases complexity for high-income tax payers and small business owners. Should the proposed bill become law significant income tax planning opportunities will still be available.
We are still evaluating the proposed legislation. Additional planning ideas will come to light as we spend more time with the proposed bill. We plan to provide more communication around tax reform planning opportunities throughout the first quarter of 2018. In the interim please contact your Wealth Manager to discuss any of the strategies mentioned above or other questions you may have regarding federal tax reform.
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