2018 Income Tax After Action Report
Now that the filing deadline for 2018 Income Taxes is behind us, I wanted to provide some lessons learned since this was the first iteration of tax returns following the passing of the Tax Cuts and Jobs Act of 2017.
As most taxpayers well know, the Tax Cuts and Jobs Act of 2017 was a sea change for income taxes. In addition to changes in the rules governing taxation, the forms used to prepare tax returns also changed rather dramatically.
Upon passage of the law, many gray areas required explanation. For example, the Qualified Business Income (QBI) deduction, which permits up to a 20% deduction of business income needed much explanation from our Treasury Department. Additionally, new rules governing the Estate Tax also needed further explaining.
In the midst of all this, we all eventually had to submit our tax returns for 2018. Indeed, the tax filing deadline is one of the few hardened due dates in the financial world. True, you can postpone that appointment with your Estate Attorney for as long as you wish. You ignore income taxes at your own peril...
Lesson #1: The new Form 1040 is difficult to follow
Originally conceived to simplify tax preparation and to allow for "1 page" preparation for most that could fit on a postcard, the Form 1040 certainly accomplished one of those goals. For those familiar with Microsoft Excel's "Print to Fit" feature, the government seems to have used that feature for the 1040.
There is a bit of a workaround called the "Form 1040 Reconciliation Worksheet" - probably available to those who have an accountant prepare their taxes. This document closely resembles the previous version of the 1040 and is a bit easier and more intuitive to follow.
Lesson #2: Tax Refunds are not a complete gauge for overall tax liability
Much was made in the press about the decrease in the size of tax refunds. Some mistakenly think a reduced refund meant the recipient did not in-fact receive a "tax cut". Nothing could be farther from the truth.
Your income tax refund is a reflection of both your tax liability AND your withholding and estimated tax payments. If I want, I can pay large sums in estimated payments and further couple those payments with large withholding from my paycheck. These two actions will force a refund once I file my tax return. However, the taxes on my income are the same either way. For completeness, you might be subject to underpayment penalties if you don't pay enough throughout the year, so it is worth the effort to spend some time on calculating your estimated taxes and withholding.
My suggestion is to go to the IRS' Withholding Calculator and go through their process. Then, make adjustments to your withholding so you have a positive, though not excessive, refund at tax time. Remember, if you receive a large refund, you are - in essence - providing the government a tax-free loan as Uncle Sam had use of your funds throughout the year. For those who for one reason or another just can't seem to save, a large tax refund can be a forced savings plan...provided you actually save the money.
Lesson #3: Itemized Deductions
For most filers, the Standard Deduction will be the new normal going forward. This is a good deal as the Standard Deduction - $24,000 for married couples, $12,000 for single folks - is quite high. When you think about median pay - which hovers somewhere around $60,000 (Source: 2017 US Census), a good deal of income in general is not subject to Income Tax. Of course, payroll taxes are a different story - any worker pays those.
One consequence of the new Standard Deduction is the elimination of the tax benefits for owning a house for some. Buying a home purely for the tax benefit is probably not the best reason to purchase one. Whatever the reason for purchase, for those with an income tax interest, the benefit of deducting mortgage interest has been mostly eliminated. Thus, the carrying cost of a house - maintenance, repairs, etc. (it's a long list) - make home ownership a good bit less attractive for those who will not itemize. So please consider all aspects of purchasing a home - and please don't borrow from your retirement funds to do it.
Lesson #4: Charitable Contributions
For the charitably inclined, the new tax code makes giving a bit more interesting. The increase in the standard deduction washed out the charitable contributions for some. It remains to be seen whether this will effect organizations reliant upon donations.
For those who are near the cusp of itemizing, a Donor Advised Fund (DAF) may make sense for you. DAFs employ the strategy referred to as "bunching" where you group multiple years' worth of donations into one year and then parse the funds out over a multi-year period. The upfront deduction for the entire contribution pushes you into Itemizing, which provides full credit for your charitable giving. The subsequent standard deduction years provide further tax benefit.
Lesson #5: The Alternative Minimum Tax (AMT) has been eliminated for most
The AMT modifications were ones about which I was most happy. Originally conceived to make tax dodgers pay their fair share, the AMT morphed into a very wide tax net. The changes to how the AMT was calculated reduced the number of those impacted by this scheme. Personally, I am very glad about this.
Lesson #6: State and Local Income Taxes (SALT)
The debate about SALT and its varying impact across the country was widely reported. The news focused the extremes on both side of the debate. The truth, as is typical, is probably somewhere in the middle. For my Clients who live in "high tax" states, they did have a SALT reduction. However, they also avoided the AMT. Everyone's situation is different.
For now, at least you have one year of Income Tax returns to gauge future years' strategies. One things seems clear, because eliminating or expanding the SALT limitation will benefit "the wealthy", it seems unlikely to change from its current form.
Lesson #7: The Benefits of Uniform Transfers to Minor Act (UTMA) and Uniform Gifts to Minors (UGMA) Accounts
The income tax treatment of UGMA and UTMA accounts changed rather dramatically in 2018. Moreover, earned income and unearned income are treated differently for minors. For unearned income, UGMA and UTMA accounts are taxed at Trust Rates, which are as follows:
- 0%: $0 - $2,600
- 15%: $2,601 - $12,700
- 20%: $12,701 and up
Of note, the first $2,100 of unearned income is deducted before you start, so effectively, you can avoid Capital Gains taxes on up to $4,700 of capital gains by gifting appreciated assets to your child and then "tax gain harvesting" the asset by selling it and immediately buying it back - it goes something like this:
There are a few nuances to this strategy, so please be sure to consult your tax advisor before pulling the trigger. That said, it does work as advertised. For those sitting on large amounts of capital gains in taxable accounts, this can be an invaluable strategy.
Lesson #9: Back Door Roth IRA
For now, the Back Door Roth IRA remains alive and well. For those unfamiliar, the concept is fairly straight-forward: you contribute to a Traditional IRA on a non-deductible basis and then convert the funds to a Roth IRA. There are no income limits for either Non-Deductible Traditional IRA contributions or Roth IRA Conversions. Taxability of Roth Conversions, of course, depends on the characterization of the funds you are converting.
The big catch here is to have no Traditional IRA assets, which you can accomplish through either Roth IRA Conversions or "roll-ins" to your qualified employer plan if it accepts them. Again, lots of nuances here, so please refer to your tax advisor if you are in doubt about any of this.
Bottom Line: a Roth IRA is one of the most powerful retirement planning tools out there, period. If you disagree, call me at (901) 318-3423 and we can talk about it. I suggest making the necessary moves to get funds into a Roth IRA if you can.
Lesson #10: Use of Qualified Plans
The use of qualified plans is thankfully on the rise - read here - to over 80% of employees. Unfortunately, the median (50% above and 50% below) account balance remain painfully low - just $62,700 for those 50-59. By nearly any objective standard, that amount will not get you very far in retirement.
Therefore, it is paramount to take advantage of these tax-preferenced plans, particularly if your employer offers generous matching contributions. The amounts stack up over time. No matter where your balance is today, you are where you are and the only way to ramp it up is to pile the cash into your qualified plan by the bucketful....save until it hurts!
To Roth or Not to Roth
I recently watched a CNBC piece about Retirement Plan investing - you can watch it here. There was some interesting back and forth about Roth versus Traditional retirement plan investing.
When it comes to retirement saving, intelligent people can come to different conclusions regarding Roth or Traditional contributions to qualified plans. Many factors come into play in this argument - current tax rates & pension income are primary factors, there are others. In my view, these arguments are mostly academic.
Practically speaking, retirement account balances in aggregate are low (see above). So the right answer is to save as much as you can - either on a Pre-Tax (Traditional) or After-Tax (Roth) basis. The differing tax rates in retirement will not be the difference between first-class and coach - it will more likely be BMW versus Mercedes. Get your account up to a few hundred grand first...then we can talk about Roth versus Traditional buckets for retirement assets.
For military members, who are fortunate to earn a pretty decent percentage of their pay tax-free (Basic Allowance for Housing (BAH), Basic Allowance for Subsistence (BAS), and COLA, Resilient Asset Management has been steering military members toward Roth TSP saving. This recommendation is obviously situation dependent, so please don't take it as Holy Writ.
A Word About Your Income Tax Return
At Resilient Asset Management, we request to see each our Client's Income Tax Return - it is the financial equivalent of a medical chart for a doctor. Just as a reputable doctor would never prescribe medicine without first looking at "the chart", a reputable Financial Planner should not prescribe financial strategies without looking at the tax return and considering the implications of suggested moves. A gross example of what can go wrong happened here.
While you should not let the tax tail "wag the dog", your Financial Planner should be mindful of what the tail might knock over in the china shop. When possible, please facilitate collaboration between your Financial Planner and your Accountant, you will be happy you did.
Income Taxes are part of everyone's lives. With the changes in the rules via the Tax Cuts and Jobs Act of 2017, it is incumbent upon all of us to be familiar with the changes and take advantage where it makes sense. If you are unsure, by all means, please seek out the assistance of a tax professional who can guide you along the tax path.