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.

Turning Uncle Sam into Santa Claus

uncle sam santa clausWe hope everyone had a great Thanksgiving holiday. We certainly did. Now starts the final countdown for 2014. Only twenty-some days to Christmas, and less than 30 days left before 2015 arrives. Hard to believe. Certainly, most everyone’s calendar is packed full for the next four weeks. We just wanted to make sure that tax planning is on your list of “must do” items before year-end. Of course, tax planning doesn’t rank in the same category as giving my mother a Christmas kiss, being with my family or watching Dickens’ “A Christmas Carol” for the fiftieth time, but it is important.

Two good reasons: none of us likes surprises and most everyone wants to take advantage of every legal way to reduce taxes. By reviewing your taxes before year-end (hopefully with your CPA), you not only see roughly where you are for the year, but also learn what you might be able to do before year-end to reduce Uncle Sam’s share of your income.

Congress is making it tough on all of us this year. They have delayed action on more than 50 business and individual tax breaks that expired on December 31, 2013. These so-called “tax extenders” include provisions that allow businesses to write off the cost of substantial equipment at a faster rate, tax credits to weatherize homes and some higher education expenses to be deducted.

The tax extenders have commonly been renewed each year, often right after elections or even retroactively at the beginning of the next year. As we go to press, the jury is still out on renewal. Even so, there are some tax breaks you should consider for 2014:

  • Consider upping your charitable contributions. This could be writing a few more or larger checks and/or giving non-cash items, like clothing, furniture and even an old car.
  • Consider giving appreciated stock to charity this year. You get a deduction for the value of the stock given, not the cost. And, you don’t pay capital gain taxes on the money if you have held the security for 12 months. If you aren’t sure of the charity you want to give the funds, you can make the gift to a donor-advised fund, such as Schwab’s, which allows you to get a deduction this year and then advise on the recipient next year.
  • Consider gifts to your family. No, there is no tax deduction for gifts. But, you can give up to $14,000 ($28,000 if you are married) to as many individuals as you like before December 31 without anyone incurring any tax. And, if you would like to, you can do it all over again on January 1, 2015.
  • Consider harvesting tax losses within your portfolio. DWM clients know that we already did this for our clients last month. It was tough again this year, as most positions for our clients are showing unrealized gains. Furthermore, remember that you can’t sell a loss position and buy it back within 30 days. That’s a “wash sale” and the IRS bars you from claiming this loss.
  • Consider paying certain items before year-end. These could include items such as real estate taxes, state income taxes, college costs, and mortgage payments.
  • Consider funding your IRA or Roth early. Yes, you have until April 15th to make the contribution for 2014, but why not get it working for you as early as possible. And, consider making 2015 contributions in early 2015.
  • Consider a Roth conversion for part of your IRA funds. Pay the tax once and allow the funds to grow tax-free forever; for your lifetime and that of your descendants. Furthermore, there are no required minimum distributions from Roth accounts starting at age 70 ½. You and your tax adviser will need to look at current and expected future tax rates to determine if this makes sense for you.
  • Check your withholding. Compare your estimated taxes to how much you have withheld. If you are way under, consider taking extra withholding in your final paychecks. And, if you are way under or way over, consider revising your withholding allowances for 2015.

So, between all the holiday festivities in December, you’ve got some homework to do. Get with your CPA and review your 2014 taxes and see if you can lower them. Let’s try to make Uncle Sam start to look like Santa Claus. Cheers!