America changed on December 22nd when President Trump signed a bill enacting the biggest tax overhaul in decades. One highlight of the new law is the near doubling of the standard deduction. Just how much this and the other changes will impact households, our economy, and our federal budget is the topic of much debate. These new tax laws won’t impact 2017 taxes that will get filed by April of this year. However, households need to understand the changes and react to them now in order to maximize their tax efficiency when they go to file their 2018 tax returns this time next year.
This post doesn’t attempt to take a political position in regard to the reformation. Instead, it will explain plainly what has changed and then will share three ways to potentially take advantage of the increased standard deduction, as this is likely the change that impacts the highest percentage of households.
What are the Biggest Changes?
Lowering of the Corporate Tax Rate: Corporations were previously taxed at 35%. This rate has been permanently slashed to 21%. While not a direct impact on household filing, the indirect impact on households will likely be material.
Same number of tax brackets, lower rates: The plan keeps seven tax brackets. The limits, however, of each bracket were increased and the tax rate was lowered in five of the seven brackets. Both moves generally mean households will owe less tax. These adjustments to the individual tax brackets along with the other changes for individuals listed below are scheduled to sunset (or end) in 2025.
Changes to State and Local Tax Deductions: Previously, households could deduct all of their state and local income, property, and sales tax without limit. Now, the federal deduction for the aggregate of all of these taxes is capped at $10,000 per year.
Increase to the Child Tax Credit: Both the amount and eligibility of this credit have been altered. Now, qualifying households can claim up to $2,000 per child under 17 (up from $1,000 previously). Additionally, households with an AGI under $200,000 for individuals (previously $75,000) and $400,000 for married filing jointly (previously $110,000) can claim the full credit.
Changes to Mortgage Interest Deduction: Households can currently deduct mortgage interest payments on mortgages up to $1M. That amount has been decreased to $750,000, although this only applies to future buyers, and is not retroactive for homes purchased when the previous tax bill was in effect.
Elimination of Personal Exemptions: Previously there was a $4,050 tax deduction for each person claimed on the tax return (both adults and children). These personal exemptions have been completely eliminated.
Near Doubling of the Standard Deduction: Perhaps the change that has the widest and deepest implications, the standard deduction has nearly doubled from $6,350 to $12,000 and from $12,700 to $24,000 for single and married filers, respectively. This should drastically impact the volume and the way by which households file their taxes. We unpack this further in the next section.
3 Ways to Capitalize on the Change in Standard Deduction
Two things are mere certainties as a result of the significant increase in the standard deduction. First, many households that previously itemized their deduction will now take the standard deduction. Secondly, most households that previously took the standard deduction and ones that now will likely pay less tax. How much they’ll save depends on how well they understand their situation, the new laws, and act accordingly. Here are a few tips:
Invest the Newfound Savings – While estimates vary, a reasonable forecast for a married, one child, and $75,000 annual income household is about $2,000 of after-tax savings per year. That’s a new $2,000 a family could use for a vacation or on other consumables. That’s also $2,000 that could be freed up for investments, and therefore presents a huge opportunity for households to make an important contribution to their future without having to make a change to their current lifestyle.
Let’s run the numbers in this example to illustrate the enormity of this opportunity.
Example: The Jones family invests an extra $2,000 in a Roth IRA each year. The investments average a return of 7% each year.
In this hypothetical, the Jones family generates almost $90,000 of additional retirement savings over 20 years simply by investing their tax savings.
Consider a 15-Year Mortgage – The rise in standard deduction has a significant impact on households with mortgages as well as those that are seeking one out. Many families that once needed the help of their mortgage interest payments in order to itemize will now end up taking the standard deduction anyway. A 15-year mortgage may now make more sense for such families. Fifteen-year mortgages generally have much lower interest rates and will result in a significantly lower amount of total interest paid over the life of the loan. Being able to deduct the interest used to help partially offset the higher interest expense over the life of the loan. If that now goes away, it’s more of a reason to focus on paying less interest and more to the principal. A 15-year mortgage accomplishes this.
Consider a Donor Advised Fund (DAF) – Along with mortgage interest payments, charitable giving is the other major component remaining for those that will continue to itemize. Like mortgage interest, the tax benefit to charitable giving diminishes if a family will end up taking the standard deduction anyway.
As Christians, our faith is what compels us to give to our church and other worthy causes. The tax deduction should be a peripheral consideration much more than a driving motivation. Said another way, we should continue to tithe and give generously as the Spirit leads regardless of the tax implications. For some families, a donor advised fund might be a vehicle that allows for increased tax advantages under the new tax laws. This can help families continue to be as generous (or more!) as before.
Funding a donor advised fund, in short, allows households to recognize a charitable deduction immediately, and then distribute the gifts to qualified churches and charities over time.
Why does this matter?
One technique, for the right situation, is to fund a DAF with multiple years of charitable giving in a single tax year and then make distributions from the DAF to the charities over time. This can allow the household to exceed the standard deduction in the year of funding the DAF, itemize their deductions for that particular year only, and thus realize greater tax savings.
It’s important to exercise caution as this technique requires a significant need for cash upfront. Households should still retain a healthy cash reserve in case an unexpected need comes along that demands cash. Most DAFs also charge annual fees. For these reasons, it’s important to carefully analyze your financial outlook to determine if this is a viable strategy for you.