Feature
It’s Official: What the New Tax Bill Means for You
By Karen Hube
Photo: Getty Images
The Tax Cuts and Jobs Act, passed by Congress today and about to be signed into law by President Donald Trump in the next day or so, is a major coup for U.S. corporations, but a mixed bag of give-and-take for individual taxpayers, with benefits sharply skewed to the wealthy.
The top corporate tax rate, which affects publicly-traded companies, will drop from 35%—one of the highest top rates levied by developed nations—to 21% in 2018. The move is roundly applauded as a necessary step to keep U.S. multinational businesses competitive with foreign companies.
But to pay for the corporate tax cut, the final bill reneges on many of its original objectives that would have benefited individual wage earners. President Trump promised tax reform that would simplify the tax code, focus tax relief on working families, and close loopholes for wealthy taxpayers and businesses. But the bill, cobbled together frenetically in closed-door cram sessions by Republicans eager to get a major legislative victory on the books before year end, does none of those things.
“Instead it is more complicated, creates more loopholes for special interests and is more unfair to the middle class than current tax rules,” says Steve Wamhoff, a senior fellow for income tax policy at the Institute on Taxation and Economic Policy, a nonpartisan think tank in Washington, D.C.
Most taxpayers will see their tax burdens decline and their after-tax income rise in 2019, after the new law is fully in effect. But the “Christmas gift to the American people,” as President Trump characterized the tax bill, is disproportionately puny for lower-income folks compared with high net worth taxpayers. While more than $300 billion in tax relief will go into effect in 2018, more than half of the benefits of the bill go to the richest 5% of taxpayers, and a quarter goes to the richest 1%.
The lowest-income quintile of taxpayers earning less than $25,000 annually should count on keeping an extra $90 a year in their pockets under the tax cut—a 0.4% bump in their after-tax income, according to the Tax Policy Center in Washington, D.C. Middle-income families earning $49,000 to $86,000 annually should expect an average tax cut of $900, increasing their after-tax income by 1.6%. Folks with incomes between $308,000 and $733,000 will see an average 4.1% improvement thanks to an average $13,500 cut; and those in the top 1%, with income of more $733,000, are in for an average $51,000 tax reduction, which should plump up after-tax income by 3.4%.
The bill maintains seven tax brackets, but reduces income tax rates for just about every taxpayer, with the top rate dropping from 39.6 % to 37%. Many currently in the top tax bracket will see their top rate drop to the second-highest tax rate of 35%, because the threshold for income taxed at the top rate has been raised from $470,701 for married couples filing jointly to $600,000.
But new limits on deductions offset the full benefit of the tax rate reductions. Most notable: A $10,000 cap on deductions for state and local income taxes and property taxes, combined. Under current law, state and local income taxes and property taxes are fully deductible on federal returns.
This hits hardest in high-tax states. Among the highest: California, New York, New Jersey, Oregon, Minnesota, Iowa and Vermont.
The bill also lowers the allowable mortgage interest deduction and scraps home equity interest deductions. Currently taxpayers can deduct interest on mortgages of up to $1 million. Effective for home purchase Dec. 15, of this year, that cap is now $750,000. The $1 million cap remains for existing homes.
Nationwide, the impact of the limit on mortgage deductions seems minimal. Only 3.5% of homes sold this year had mortgages of more than $750,000, according to Attom Data Solutions, a real estate research firm in Irvine, Calif. But put the spotlight on some high-cost areas of the country and the impact looks far different: In New York City, 64% of new mortgages are valued over $750,000, and in San Francisco, 58%.
“Concern is that we’ll see fewer sales of existing homes because homeowners won’t move if they don’t get the deductions they want on a new mortgage,” says Dan North, chief economist at Euler Hermes North America in Baltimore, Md. “This could mean a drop in home values.”
A welcome change is to the alternative minimum tax. Exemptions have been raised from $84,500 for couples filing jointly to $109,400, and the phase-out income threshold for the exemption has been raised from $160,900 for couple to $1 million.
A more controversial measure is the scrapping of personal exemptions, currently $4,050 per family member. In an attempt to offset this, the standard deduction has been raised to from $6,350 for singles and $12,700 for couples filing jointly to $12,000 and $24,000.
In addition, the child tax credit has been doubled, from $1,000 to $2,000, and income limits on who may claim the credit have been substantially increased, from $75,000 for singles and $110,000 for couples to $200,000 and $400,000. Under threat by Senator Marco Rubio to oppose the bill, lawmakers also raised the refundable amount to $1,400 when the credit is larger than income tax liability.
How well the standard deduction and child tax credit increases counterbalance the loss of the personal exemption depends on family size and whether a family itemizes deductions.
This year, a family of four earning, say, $300,000 will get a $28,900 in combined standard deduction and personal exemptions, assuming they don’t itemize. If they do, their total would be higher. The family doesn’t qualify for the child tax credit.
Under the new law, the family qualifies for the child tax credit and would likely take the standard deduction, because it will be so much higher, but the personal exemptions fall away.
The total benefit drops to $28,000.
For a family of six at that income level, this year the benefit would be $35,700; under the new bill it will drop to $32,000.
Ultimately, how the bill shakes out for each individual or family depends on income and wealth level, family size, what state you live in and whether you own a home, among other factors.
Tim Steffen, director of advanced planning at Baird Private Wealth Management, ran various tax analyses for different hypothetical families around the country to understand the tax impact of the new law. He assumed incomes ranging from $100,000 to $1 million a year, and high tax, low tax and no income tax states.
In most cases, he says, the lower tax rates outweigh the disadvantage of the trimmed deductions under the new law.
At income levels of $100,000 and $500,000, his hypothetical families had the same federal tax burden regardless of whether they lived in a high, low or no-tax state. That’s because the cap on state property and income tax deductions equalizes their situations.
Families in high-tax states get the lowest tax savings under the bill, because under current law they are paying the lowest federal taxes due to their large state income and property tax deductions, so they feel the loss of those deductions the hardest.
At the $1 million income level, the loss of state tax deductions is more likely to cause an increase in tax burden, according to Steffen’s analysis. Consider a family of four in Westchester County, N.Y., a New York City suburb, with a $2 million home, a mortgage balance of $1.2 million, a state tax bill of $67,000, and a $40,000 property tax.
Based on those and other assumptions, the family’s federal tax would be $275,675 this year, and $276,079 next year.
If the same family were based in Hillsborough County, Fla., where there is no state income tax, this year its federal liability would be $308,579. Under the new tax bill, it would drop significantly, to $276,079.
Generally, under the new plan, the greater the income and wealth levels, the greater the total tax savings. For most wealthy families, you have to look beyond just income taxes to understand their full benefit, says Matt Gardner, a senior fellow at the Institute on Taxation and Economic Policy.
The estate tax, while still in effect under the new bill, will kick in at much higher income levels thanks to a doubling of the exemption from the current $5.49 million for individuals to $10.98 million. Couples will be able to shelter $21.96 million from the estate tax.
Most owners of pass-through entities such as S corps and limited liability companies will see a much-welcome 20% deduction on income. While this will be welcome for small operating businesses, two-thirds of pass-through entities are owned by the top percentile of taxpayers, “so this is the equivalent of giving a big tax break to the wealthy,” Gardner says.
The benefits to most individual taxpayers are scheduled to expire in 2025—a strategy put in place to keep the cost of the bill below a $1.5 trillion threshold to enable, under congressional rules, Republicans to push the bill through without a so-called simple majority, in this case meaning they didn’t have to rely on support from Democrats.
Wealthy taxpayers, meanwhile, are expected to continue to benefit from the only major permanent provision under the bill—the reduction in the corporate tax rate. Most shareholder wealth is concentrated among the wealthy, and as corporations benefit from their lower tax burden, so, too, will shareholders in the form of higher dividends and rising stock prices.
While Republicans claim the benefit to corporations will ultimately trickle down to the working class through pay raises and job expansion, many economists are dubious, as this hasn’t been borne out in history.
For now, some year-end moves could save some taxpayers a bundle. Consider, for example, prepaying any 2017 state taxes that you would normally push into 2018.
Many taxpayers underpay state and local taxes in a given calendar year due to under-withholding, and make their final payments in the next year by the April 15 tax-filing deadline. And for those who file estimated quarterly taxes, their fourth-quarter tax payment isn’t due till January of the following year.
Usually, taxpayers prefer to hold off paying taxes until necessary. “But prepaying is a way to take advantage of state tax deductions, which are going away next year,” says Lisa Featherngill, managing director of wealth planning at Abbot Downing.
For folks paying the alternative minimum tax, typically those earning between $200,000 and $500,000, this is a moot point because they don’t get the benefit of the state tax deduction anyway. “Have your accountant run the numbers,” Featherngill advises.
Another tax-saving move: With the standard deduction raised to $24,000, many folks will take the standard deduction rather than itemize. Taxpayers itemize their deductions when total deductions exceed the standard deduction.
“Figure someone who doesn’t have a mortgage will be taking the annual maximum allowable $10,000 deduction for state and local taxes next year, and makes a $10,000 yearly charitable gift. They’d have $20,000 in deductions, which means they’d take the standard deduction,” Featherngill says. “That deduction for the charitable contribution would be lost.”
So consider clustering those planned future $10,000 gifts into 2017. That’s an extra $50,000 deduction this year, compared with no tax benefit for the gifts if they were spread over future years.
Most planning opportunities will be next year. The new estate tax exemption will prompt a flurry of estate plan revisions, and the change in tax rates on businesses warrants a hard look at how wealth is structured.
“We’re going to see pass-through owners asking if they should be structured as C corporations to take advantage of the new top 21% tax rate,” says Jim Wilhelm, director of SC&H Group, a tax consulting firm in Glencoe, Md. Pass-through income is taxed at income tax rates, up to 37% under the new law.
Aside from the lower tax rate, corporations can deduct state and local taxes under new rules, while pass-throughs can’t.
Folks subject to income tax rates with flexibility on how they claim their income will inevitably explore creating a pass-through entity to pay out their income, so they can get that new 20% deduction.
The varying new benefits and rates on individual, pass-through and corporate income set the stage for years of scheming and mining through the tax code for new ways to game the system, Wilhelm says. Without the simplification of the tax code, it’s a different set of rules, but the same game.
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