HOW TO AVOID A 2018 INCOME TAX SHOCK

Did your paycheck get a nice bump in the last few weeks? Employers are just starting to use the newly issued IRS withholding tables for 2018. All things being equal, employees may see a 5%-15% reduction in their federal tax withholding, resulting in a boost in their take home pay. Who doesn’t love that? However, the question is, when you file your 2018 tax return a year from now, will you owe a substantial amount? Has your withholding been reduced too much? How do you avoid a tax shock?

The various changes of tax reform passed in December plus lower withholding may lead to unexpected results. Itemized deductions were generally reduced; in some cases, in major ways. Standard deductions were doubled. Income tax rates were lowered. Exemptions were eliminated. Lots of moving pieces to consider.

Let’s take a look at an example, as presented by the WSJ last Saturday. Sarah is a New York resident. For 2017, she had $200,000 of wages and other income and $33,000 of itemized deductions, including $28,000 for state and local income taxes. Her federal tax, including AMT, was $41,400. Her withholding was set at $41,500, so that she would receive a tax refund of about $100.

For 2018, Sarah has the same income and deductions, and she doesn’t adjust her withholding certificate, even though her itemized deductions are reduced by $18,000 to $15,000. Using the 2018 withholding tables and her withholding certificate (W-4) from 2017, her employer reduces her withholding and increases her take-home pay by $5,300, about $100 per week.

Here’s the problem: Because her deductions were greatly reduced and she lost her personal exemption, her income taxes will only be reduced by $500 in 2018. She’ll owe $4,700 (plus a penalty for underpayment) come April 2019.

All taxpayers, even those that don’t get paychecks, need to get ahead of curve and project their income taxes for 2018 and review how tax reform is going to impact them. You need to do it early. Sarah can change her withholding now (by increasing withholding $100 per week-back to what it was) to avoid a big tax shock in April 2019. In addition, as you and your tax professional review the elements of your 2018 projection, you may identify some changes that made now could reduce your ultimate 2018 income taxes.

The IRS has put together a withholding calculator, https://www.irs.gov/individuals/irs-withholding-calculator that seems to work fairly well with simple returns. It’s a “black box” with little detail of the calculations.

At DWM, we consider our role in tax planning a very important element of the value we provide to our Total Wealth Management clients. We don’t prepare returns. However, since our inception, we’ve been doing projections focused on eliminating surprises and often finding potential tax savings ideas to review with our clients and their CPAs. This year we are using BNA Income Tax Planner software to make sure that all the new tax provisions are being considered and calculated properly as we are doing the projections. We’ve done about dozen so far.

We’ve already seen some major eliminations of itemized deductions on projections we’ve done. One couple lost over $100,000 of itemized deductions, primarily due to the new $10,000 cap on state and local income taxes and elimination of miscellaneous deductions. Similar to the example above, without a change in their W-4s and, therefore, a change in their withholding, they would have owed over $30,000 in federal taxes in April 2019.

Tax reform didn’t have much impact on IL income taxes, as taxes are passed primarily on adjusted gross income. However, the full year tax rate of 4.95% in IL is roughly 16% more than the effective 2017 rate. In SC, where the state tax is based on taxable income, the tax will generally be going up for those taxpayers with large itemized deductions in the past. SC tax in 2018 will likely rise at the rate of 7% of the amount of lowered deductions and exemptions as compared to 2017, all other items being equal.

We encourage you to prepare or get assistance to prepare a 2018 income tax projection now and check it in the fall as well. Even if you haven’t received a larger paycheck recently, it’s really important to go through this process to avoid tax shocks and, maybe, even find some opportunities to reduce your taxes for 2018.

TAX REFORM: THIS YEAR’S CHRISTMAS GIFT OR A FUTURE CHRISTMAS COAL?

On top of the regular holiday season’s festivities, this year we’re watching the proposed “Tax Cuts and Jobs Act” likely making its way to the President’s desk for signature. The “joint conference committee” announced yesterday that they have a “final deal” and Congress is scheduled to vote on this next week.  Before we review what we specifically know about the bill (not all details have been released as of this morning) and provide some recommendations concerning it, let’s step back and review it from a longer-term perspective.

Since last year’s election, stock markets have been on a tear- up over 20%, mostly driven by increased corporate profits, both here and abroad.  U.S. GDP is growing and unemployment is close to 4%.  Most economists believe that now is not the time for a tax cut, which could heat up an already expanding economy to produce some additional short-term growth and inflation. The Fed reported yesterday that the tax package should provide only modest upside, concentrated mostly in 2018 and have little impact on long-term growth, currently estimated at 1.8%.  So, tax cuts now will not only likely increase the federal deficit by $1.5-$2 trillion over the next decade, but will take away the possibility of using tax cuts in the future, needed to spur the economy when the next recession hits.  Certainly, we would all like lower ta

xes and even higher returns on our investments, but we’d prefer to see longer-term healthy economic growth with its benefits widely shared by all Americans and steady investment returns, rather than a boom-bust scenario and huge tax cuts primarily for the wealthy that may not increase long-term economic growth.

As of this morning, December 14th, here are the current major provisions:

Individual

  • Income Tax Rates.  The top tax rate will be cut from 39.6% to 37%.
  • Standard deduction and exemptions.  Double the standard deduction (to $24,000 for a married couple) and eliminate all exemptions ($4,050 each).
  • State and Local Income, Sales and Real Estate Taxes.  Limit the total deduction for theseto $10,000 per year.
  • Mortgage Interest.  The bill would limit the deduction to acquisition indebtedness up to $750,000.
  • Limitations on itemized deductions for those couples earning greater than $313,800.  Repeals this “Pease” limitation.
  • Roth recharacterizations.  No longer allowed.
  • Sale of principal residence exclusion.  Qualification changed from living there 2 of 5 years to five out of eight years.
  • Major items basically unchanged.  Capital gains/dividends tax rate, medical expense deductions, student loan interest deductions, charitable deductions, investment income tax of 3.8%, retirement savings incentives, Alternative Minimum Tax, carried interest deduction (though 3 yr. holding period required.)
  • Estate Taxes.  Double the estate tax exemption from $5.5 million per person to $11 million.

 

 

Business

  • Top C-Corporation Tax Rate.  Reduce to 21% from 35%.
  • Alternative Minimum Tax.  Eliminated.
  • Business Investments.  Immediate expensing for qualified property for next five years.
  • Interest Expense.  Limit on expense to 30% of business interest income plus 30% of adjusted EBITDA.  Full deduction for small businesses (defined as $25 million sales by House, $15 million by Senate).

Another key issue, the top rate on pass through organizations (such as partnerships and S Corps), is yet to be determined. However, it appears that a reduction of 20% to 23% will be available to pass-through income, subject to W-2 minimums and adjusted gross income maximums. This would produce an effective top rate of 29.6% on pass through income.

If all of that see

 

ms confusing, you’re not alone.  Lots of moving parts and lots of details still to be clarified. Even so, if the bill passes, you will have been smart to consider the following:

Recommendations:

1) Because the bill would limit deductions for local income, sales and real estate taxes, you should make sure that you have paid all state income tax payments before December 31, 2017. If you are not sure, pay a little extra.

2) Also, make sure you pay your 2017 real estate taxes in full before 12/31/17. Because Illinois real estate taxes are paid in “arrears” it will be necessary to obtain an estimated 2017 real estate tax bill (generally due in 2018) by g

 

oing to your county link and then paying this before 12/31/17.  Let us know if you need help on this.  In the Low country, while our CPA friends indicate that paying 2018 real estate taxes in 2017 should be deductible, as a practical matter, there appears to be no way to get an estimated tax bill for 2018 and prepay your 2018 real estate taxes in 2017.

3) Meet with us and/or your CPA in early 2018 to review the impact of the Act, assuming it becomes law, on your 2018 income tax planning. It will be important to review the various strategies that may be available to make sure you are paying the least amount of taxes. 

Yes, tax reform may be here before Christmas. Not sure what it will be: a wonderful gift for this year’s holiday or perhaps a lump of coal in our stockings for Christmases to come.  Stay tuned.

Simplifying the Tax Code

 

Simplifying the income tax codeMillions of Americans participated this week in the annual ritual of filing income taxes-probably cursing this confusing, complicated process. While many politicians rail about the complexity of the tax system, few are actually willing to support meaningful simplification efforts. The chart above demonstrates the problem.

 

Current individual income tax breaks exceed $1 trillion per year. It may come as a surprise that the largest is the exclusion for employer-provided health insurance coverage. If taxed, Uncle Sam would get an extra $164 billion in annual revenue but employers might drop coverage and get out of the health insurance business for their employees. The mortgage interest deduction costs U.S. coffers $100 billion annually. But repealing that deduction would raise the cost of housing for homeowners and likely cause a further drop in home prices. Eliminating deductions for charitable donations would certainly hurt not-for-profits at a time when many are already struggling from reduced state and federal support.

 

Two years ago, Alan Simpson and Erskine Bowles, co-chairmen of the National Commission on Fiscal Responsibility and Reform put forward a plan to wipe the slate clean and start from scratch. They proposed eliminating all deductions, exclusions and credit and provide three tax brackets; 8%, 14% and 23%. The Simpson-Bowles proposal, which also included huge budget cuts, was finally brought to a vote in the house on March 28. It received only 38 votes. The fact is that the majority of the “tax breaks” are immensely popular and have become imbedded in our economy and society. Americans are not prepared to live without them.

 

Recently, Professor Michael Graetz of Columbia Law School came up with another possible solution. He would abolish the income tax for most Americans and replace the revenue with a 12.5% value-added-tax. Prof. Graetz would give each family a $100,000 tax exemption, which would eliminate income tax for 90% of those currently filing. For those with income above $100,000, top tax rates would be 20-25% on taxable income. Mr. Graetz outlined the details in his 2007 book “100 Million Unnecessary Returns.” His basic concept is that if the current tax breaks are so much a fabric of our society that their elimination is unlikely, then make them irrelevant to most Americans by instilling a large exemption and a new VAT tax.

Very interesting.