By Amber Gutschlag
The Tax Cuts and Jobs Act contains historic changes to the United States tax code and will likely affect every taxpayer in some way. These reforms may result in profound increases or decreases in the tax liability of high net worth individuals. The following topics are just a sample of the changes that could affect a high-income taxpayer in 2018 and future years. If you don’t consider yourself in this subset yet, read on to see how these reforms create opportunities to plan for your family's future as well.
The 2017 tax reform bill doubled the estate tax exemption to $10 million per individual, indexed for inflation. This means that taxpayers who pass away in 2018 can leave a cumulative $11.2 million to their heirs before incurring estate tax. Couples in community property states essentially have double this amount or $22.4 million to pass on without tax. The top estate tax rate for taxable estates over this exclusion remains 40%, and any unused exemption is still available to "port" to a surviving spouse.
Planning Opportunity - Net Worth Over the Exemption
The increase in the estate exemption only remains in effect through 2025 without further action by Congress. After that, it will revert back to the $5 million exclusion, with an inflation adjustment. Individuals with estates that could exceed the exemption should continue to consider annual gifts of $15,000 (in 2018) per person each year to reduce their taxable estate. Additional gifting of investments, property or entity ownership may be attractive again, particularly if the taxpayer has previously used up the lifetime exemption on prior year gifts.
Planning Opportunity - Net Worth Under the Exemption
Typically when a taxpayers passes away and leave assets to their heirs, the property receives a step-up in basis to the fair market value of the asset on the date of death. This feature remains in effect under the new reforms. If a taxpayer's estate is projected to be under the exemption, a taxpayer should consider holding appreciated assets and allowing them to transfer to the heirs after death. When the heirs later sell the assets, the taxable gain will be significantly reduced.
Three significant changes will affect itemized deductions for high-income taxpayers in 2018 and beyond - the state & local tax deduction, miscellaneous 2% itemized deductions and the itemized deduction phaseout.
- State & Local Taxes
Under tax reform, the itemized deduction for state and local property taxes will be limited to $10,000 ($5,000 if married filing separately). This limit applies to state income taxes or sales taxes and property taxes. Even taxpayers with a modest income and an average home value may be limited.
- Miscellaneous 2% Itemized Deductions
Prior law allowed a taxpayer to deduct expenses incurred for the production or collection of income (investment expenses, advisory fees, unreimbursed employee expenses, etc.). These costs in total would have to exceed 2% of a taxpayer's adjusted gross income, and the remaining expenses were considered an itemized deduction. The new tax law repeals this deduction. We anticipate that a shift in investment service fees will follow, with brokers likely adding their fees to the basis of purchased assets, versus charging fees on the value of the account. Taxpayers that are invested in passthrough entities with investment expenses will also lose those deductions.
- Itemized Deduction Phaseout
In a win for high-income taxpayers, the Tax Cuts and Jobs Act repealed the 3% phaseout of itemized deductions. Previously, the total itemized deduction was reduced by 3% of the amount that the taxpayer's adjusted gross income exceeded a threshold, but not more than 80% of total itemized deductions. The new law suspends the limitation, and taxpayers can now deduct their itemized expenses in full without restriction.
Qualified education plans continue to be a popular gift and investment strategy to pay for education expenses. Anyone can make contributions to a qualified plan - parents, grandparents, godparents - which has made this an attractive method for gifting. Under a qualified plan, distributions of principal and earnings used for qualified education expenses are tax-free to a plan beneficiary.
Before tax reform, qualified expenses were limited to post-high school expenses. The Act now allows distributions for elementary and secondary school expenses as well. This means that K-12 private school or homeschool expenses will qualify, and education plan distributions used to pay for those costs will also be tax-free. The catch - the law also enacts a new limit of $10,000 of distributions per student per year.
Miscellaneous Tax Reform Provisions
- The top individual tax rate is now 37%, compared to 39.6% before reform. For married filing jointly taxpayers, the threshold to reach the top tax bracket is now $600,000, versus $470,700 in the prior year. Withholding on wages should reflect these new brackets no later than your February 15, 2018 paycheck.
- The new law raised the Alternative Minimum Tax (AMT) exemption to $109,400 for married taxpayers filing jointly, and this exemption will not phase out until income reaches $1,000,000 - so fewer taxpayers should be subject to AMT.
- Personal exemptions for taxpayers and their dependents are repealed.
Each taxpayer is unique and will have opportunities to take advantage of tax reform benefits. If you want to know more about how the new law will affect your personal tax liability or estate plan, please contact GPP today!
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.