Revisit your plan for deductions under the new higher standard deduction
Potentially use 529 plans to pay for primary and secondary education
Consider changing your business structure to take advantage of new pass-through income rules
Major changes in tax policy last year—the biggest reform in 30 years—have given investors a lot to consider in their financial planning.
Perhaps the most direct impact has been the decline in tax rates for most tax brackets, including a move down to 24% from 28% for the middle bracket and down to 37% from 39.6% for the top bracket. The lowest bracket remains at 10% for those with less than $9,525 in annual income.
Let’s look at some of the more significant changes to the tax policy, as well as some things that have remained the same.
Higher Standard Deductions
This year, one of the major benefits for many individual taxpayers is the higher standard deduction, which is now $12,000 for individuals—up from $6,350 last year. And for married couples filing jointly, that deduction is $24,000 now, up from $12,700 in 2017.
With nearly double the standard deduction, taxpayers who itemize should consider whether that strategy is still in their best interest. If your deductions—such as charitable donations or interest on student loans—exceed the higher standard deduction, it pays to itemize.
Who is likely affected: Taxpayers who plan to claim itemized deductions. The deduction may offer a larger break to those with lower total deductions than the new standard, while having no impact on those with higher itemized deductions.
What to consider: Evaluate how your itemized deductions compare to the standard deduction. Some taxpayers may find that itemizing is no longer necessary with the higher standard deduction. Those who have deductions that total more than the new deduction might consider checking to see if itemizing may provide a better benefit for them.
Limited Mortgage Deductions
Here’s another change: homeowners can only deduct interest on mortgages of up to $750,000, down from the $1 million amount allowed by the previous tax policy. This also applies to home equity loans if they are used to purchase a second property. And interest paid on home equity lines of credit is no longer tax deductible.
Make taxes a little less taxing.
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Who is likely affected: Homeowners with an outstanding mortgage exceeding $750,000, plus anyone who may have counted on taking a deduction for money drawn from a home equity line of credit.
What to consider: If you’re thinking about buying a home and have a substantial amount of cash, it might make sense to ask a tax professional regarding considerations of using some cash in your mortgage lending choices.
Business Income Deductions
The tax reform also brings major changes for the way business income is taxed. For C corporations, in which the business income is taxed separately from owners’ income, the tax rate was cut to 21% from 35%.
Other businesses, or “pass-through” entities—sole proprietorships, LLCs, partnerships, and S corporations (which have fewer than 100 shareholders and are typically taxed as a partnership)—are also affected. Many of these business owners will see a new deduction of 20% for qualified “pass-through” business income, a popular form of business income that is not taxed at the corporate level.
For many business owners, the revised deduction would reduce their income and provide tax savings found in a lower tax bracket. For example, those in a high tax bracket with a 37% tax rate could possibly bump down to a tax bracket with the lower rate of 29.6%.
Who is likely affected: Business owners of pass-through entities who take pass-through income. This deduction is reduced if the owner’s income is more than $157,500 if filing individually, or $315,000 if married filing jointly.
What to consider: Explore your alternatives to best take advantage of these changes. A tax professional can help you evaluate these decisions, which can be complex.
Expanded 529 Plans for Education
Traditionally, 529 savings accounts were strictly to help families save for a college education. They allow funds to grow tax-free until withdrawn for qualified education expenses such as tuition, supplies, computer equipment, and in many cases, room and board. However, for federal tax purposes, the new changes have expanded the accepted use for these plans to include the attendance costs for both primary and secondary education. Qualified expenses include tuition and books, but not uniforms, transportation, or room and board. In many, but not all states, these new uses have been approved for state tax benefits as well. Check with your state to see if the list of qualified uses has been expanded.
So, with a wider breadth of coverage, these tax-advantaged plans are now appealing to more investors. In addition to college-related costs, 529s can now help pay for private or religious elementary and secondary school tuition. For primary education (K-12) expenses, funds in a 529 account can be used to pay for up to $10,000 each year per student (there’s no limit for qualified college expenses). Contribution limits are unchanged at $15,000 per year for individuals and $30,000 for joint filers.
Who is likely affected: Investors who want to use a tax-advantaged plan to help finance a child’s education from kindergarten through college.
What to consider: Decide the extent to which a 529 plan can help pay for education, including for private or religious elementary or secondary schools. Research the various 529 plans available to you and compare their fees and investment strategies. Explore your state-offered 529 plan, which may offer a state tax deduction as well. Finally, since 529 plan benefits vary depending on the state, and laws affecting 529s can change, you might want to consult a tax adviser to make sure all tax implications are considered.
An investor should consider a Plan’s investment objectives, risks, charges and expenses before investing.
Investors should consider before investing whether their or their beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program and should consult their tax advisor, attorney and/or other advisor regarding their specific legal, investment or tax situation.
Although the tax policy went through considerable changes, some policies that taxpayers feared would change have remained the same. For example, taxes on capital gains and on dividends still start at 15% for taxpayers in the lower brackets and up to 23.8% for those in the highest. And retirement accounts like traditional and Roth 401(k)s and IRAs continue to provide the same tax breaks.
For traditional IRAs and employer-offered 401(k) plans, taxpayers can deduct any contributions made to these accounts from their income tax, and delay paying a tax until they withdraw the money in retirement years. For Roth accounts, investors who deposited funds over the years can continue to rely on that money not being taxed when they withdraw it.
Who is likely affected: Investors who have assets that have capital gains and dividends or who hold or are considering tax-advantaged retirement accounts.
What to consider: If you believe the designed tax benefits are suitable for your situation, consider opening a tax-advantaged retirement account.
The Bottom Line
Generally, the tax reform this year has provided a number of ways for investors to benefit. By understating details, you may find ways to cut back your tax bill or increase your refund, which will allow you to pursue other financial goals with the savings and return.