On Dec. 22, 2017, President Trump signed into law H.R. 1, or The Tax Cuts and Jobs Act (TCJA) -- the first major tax reform since 1986. With 2017's tax season wrapping up, now is a good time for Americans to see how the TCJA will affect their tax situation going forward.
Below is a case study approach to help better understand the TCJA, illustrating how the new law affects different hypothetical clients, and highlighting the most significant changes to the law.
The Basics - Increasing the Standard Deduction and Lowering Tax Rates
- Age 30, single, lives in Salt Lake City, Utah
- No children or dependents
- Earns $70,000 per year in salary and has no other income
- He rents and does not itemize his deductions (his standard deduction is greater than his itemized deductions)
2017 (Previous Law) 2018 (TCJA)
|Wages/ Adjusted Gross Income||$70,000||$70,000|
|Personal Exemptions||$4,050 (1x)||N/A|
|State Tax (UT)||$3,500||$3,318|
|Marginal Tax Bracket (Federal/State)||25%/5%||22%/5%|
Bottom line: Mark will save $2,127 in taxes. Why? Lower taxable income (due to the increase in the standard deduction) plus generally lower tax rates result in less taxes for Mark.
Lower Taxable Income - Benefits of the Increased Standard Deduction
In 2017 the standard deduction was $6,350. Mark also had the ability to utilize a personal exemption deduction of $4,050 for total deductions of $10,400. Under the TCJA, the personal exemption deduction is repealed, but that negative change is generally offset by nearly doubling the standard deduction to $12,000 for single filers, and $24,000 for those married filing jointly. The result is that even with the loss of the $4,050 personal exemption deduction, Mark's deductions increase by $1,600 ($10,400 in 2017 vs. $12,000 in 2018), lowering his taxable income.
Reduced Tax Rates
The TCJA retains the same number of tax brackets (seven) as the previous law, but it reduces most rates and expands the threshold for most income levels, including lowering the highest tax rate from 39.6% to 37%. For Mark, his highest marginal bracket goes down from 25% in 2017 to 22% in 2018, which will also benefit and help reduce the taxes he owes.
Because Mark does not itemize his deductions, he will pay less taxes under the TCJA due to his lower taxable income amount (due to the increase of the standard deduction) and his lower marginal and effective tax rates. The above example reflects the impact that the higher standard deduction and lower tax rates will have for most taxpayers. Generally, if you use the standard deduction in prior years, your taxes will likely decrease.
The Impact of the Tax Act on a Family, Benefits of the Expansion of the Child Tax Credit
John and Cindy South
- Married and live in Atlanta, Georgia
- Have two children, ages 1 and 3
- Household income of $150,000
- They rent, and currently do not itemize their deductions
|Wages/ Adjusted Gross Income||$150,000||$150,000|
|Personal Exemptions||$16,200 (4x)||N/A|
|Tentative Federal Tax||$21,753||$19,599|
|Child Tax Credit||$0||$4,000|
|Federal Tax Owed||$21,753||15,599|
|State Tax (GA)||$7,756||$7,756|
|Marginal Tax Bracket (Federal/State)||25%/6%||22%/6%|
Bottom line: Even with the loss of the large deduction from personal exemptions, John and Cindy will still save $6,154 in taxes by being eligible for the newly expanded child tax credit, the increased standard deduction and reduced tax rates.
The Tax Trade-Off - Repeal of the Personal Exemption with Expansion of Child Tax Credit
Before the TCJA, taxpayers were able to obtain a personal exemption deduction of $4,050 or a portion of this deduction for each family member (including dependent children) if their adjusted gross income was under $436,300 for married couples filing jointly or $384,000 if filing as a single filer. Since the Souths have two children, they would be able to take four total personal exemptions -- or four times $4,050, which is equal to $16,200 -- as a deduction on their 2017 tax return. This deduction is repealed by the TCJA, and as a result their taxable income in 2018 (even with the increase in standard deduction to $24,000 for married filing jointly) is higher than their 2017 taxable income.
The negative impact of the repeal is offset by the previously mentioned lower tax rates and the increased availability of the Child Tax Credit. Under previous law, a family was allowed a $1,000 tax credit for each dependent, qualifying child. In order to be eligible, a married couple's adjusted gross income needed to be under $110,000, and that is why the Souths could not use this credit in 2017, since their income was $150,000 in 2017. Under the TCJA, the Souths would be eligible for the credit, since the AGI threshold has now been increased to $400,000 (for those married filing jointly), and the amount of the credit has also been increased to $2,000 per qualifying child. They will therefore obtain a $4,000 child tax credit, which will offset taxes owed on a dollar-by-dollar basis.
The expansion of the child tax credit was done to offset the negative impact of losing personal exemption deductions. Since credits reduce taxes owed on a dollar-by-dollar basis, credits are generally more valuable than deductions.
The Impact of Increasing the Standard Deduction - The Diminishing Value of Itemized Deductions
Craig and Mary Smith
- Married with no children
- Live in Columbia, Missouri
- Household income of $115,000
- Own a home with a $200,000 mortgage and pay about $7,500 per year in interest
- They make deductible annual contributions to a local charity of $2,000 a year
|Wages/ Adjusted Gross Income||$115,000||$115,000|
|Deduction||$16,479 (Itemized)||$24,000 (Standard)|
|Personal Exemptions||$8,100 (2x)||N/A|
|State Tax (MO)||$4,579||$5,059|
|Marginal Tax Bracket (Federal/State)||25%/6%||22%/6%|
Bottom line: Due to the substantial increase of Standard Deductions, Craig and Mary will not be able to itemize deductions, which they previously used for the 2017 tax year, reducing the value of these deductions.
The Diminishing Value of Itemized Deductions
|State Income Taxes (Wages)||$4,579|
Due to the increase of the standard deduction to $24,000 for those who are married and file jointly, the Smiths will use the standard deduction amount, since it is greater than the their total itemized deductions. As a result, the deductions they received for items such as mortgage interest and property taxes will not be as valuable for the Smiths. Finally, would the Smiths still make charitable contributions, considering there is no tax benefit for them?
This example reflects the concerns that real estate professionals and charities have about the new tax act. If fewer people itemize their deductions, which will likely be the case with the increase of the standard deduction, will individuals still purchase homes or give to charities, since there may no longer be a tax incentive to do so?
High-Income Married Couple - Impact of State and Local Income Tax Limitation
Richard and Karen Douglas
- Married with two dependent children
- Live in San Francisco, California
- Their adjusted gross income is $1 million
- They pay $40,000 annually in mortgage interest and $20,000 in property taxes
- They also make annual charitable contributions of $30,000 per year
|Wages/ Adjusted Gross Income||$1,000,000||$1,000,000|
|State Tax (CA)||$89,652||$89,253|
|Marginal Tax Bracket (Federal/State)||39.6%/11.3%||37%/11.3%|
|Effective Marginal Tax Rate on next $1000 (Fed/St)||41.7%/12%||37.9%/12%|
Bottom line: Even with the loss of over $79,066 in itemized deductions in 2018 due in part to the capping of state and local income tax deductions to $10,000 under the new law, the Douglases' federal taxes increase only slightly, by about $1,538. This may be surprising given the amount of deductions lost but this is balanced out by the other favorable aspects of the law (including the lower tax rates)
Overview of 2017 Taxes - Non- capping of State and Local Income Taxes (SALT) & Phase Out of Personal Exemptions
For 2017, the Douglases' itemized deductions would be $159,066 and are broken down as follows:
|State Income Taxes (Wages)||$89,652|
|Deduction Available (Pease Limitation)||$159,066|
Under the previous law, the Douglases would be able to apply the full amount that they paid for state and local income taxes, including property taxes, to determine their itemized deduction amounts. In 2017, if taxpayers' adjusted gross income exceeds certain levels ($261,500 for single filers and $313,800 for those who are married and filing jointly) the total amount of itemized deductions that can be used is reduced, also known as the Pease Limitation. Therefore, even though the Douglases' total itemized deductions are $179,652, their total eligible deduction due to the Pease limitation is capped at $159,066.
The personal exemptions in place for 2017 also phase out at adjusted gross income levels similar to the itemized deduction phase-out, but unlike itemized deductions, personal deductions completely phase out when taxpayers exceed certain adjusted gross income thresholds ($436,300 for those married filing jointly). The Douglases' adjusted gross income exceeds this amount, and therefore they will not be able to take any personal exemption deductions in 2017. In this case, the Douglases are not negatively impacted by the repeal of the personal exemption under the TCJA since they were not able to utilize personal exemption deductions in the previous year.
Overview of 2018 Taxes - Impact on the Capping of SALT Deductions
One of the major modifications under the TCJA for itemized deductions is the capping of state and local tax (SALT) deductions to $10,000. Since most of the Douglases' deductions consist of SALT deductions, the amount of itemized deductions they can take for 2018 is significantly decreased, resulting in losing $79,066 in deductions for 2018 tax year.
Even though they lose a large portion of their itemized deductions, the Douglases' federal tax still goes down slightly due to the lower marginal and effective tax rate for 2018 (37% and 37.9%) vs. 2017 (39.6% and 41.7%).
The capping of SALT will impact taxpayers in states with high income tax rates, such as California and New York, resulting in those taxpayers losing significant deductions that they were able to take previously. Even though their federal income taxes will generally not change significantly from previous years, they will not receive the same level of savings on their federal taxes than high-income taxpayers who live in states with lower income tax rates will.
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