Tax Cuts and Jobs Act (TCJA)
The Tax Cuts and Jobs Act (TCJA) will make tax planning a little bit challenging. The intentions of lawmakers was to essentially simplify the tax code, but strategies that made sense in prior years may no longer make sense, while new tax saving/planning opportunities become available.
First of all, you need to be be aware that the TCJA reduces the rates for all individual income tax brackets except the 35% and 10% brackets, and adjusts the income ranges for each bracket. 2020 individual income tax rate schedules
The rates apply to ordinary income, which includes salary, wages, income from self-employment, or other business activities, interest, and distributions from tax deferred retirement accounts.
There are other taxes you need to consider as well, such as the alternative minimum tax (AMT) and employment taxes.
You also need to consider various tax deductions and credits that could possibly save you a substantial amount of taxes. The Tax Cuts and Jobs Act expands various tax breaks, but it also reduces or eliminates tax breaks that had been valuable to a lot taxpayers. You will need to consider that income based phaseouts and various limits can reduce or eliminate the benefits of these tax breaks, essentially increasing your marginal/effective tax rate.
At the end of the day, the impact of the Tax Cuts and Jobs Act is what will determine whether you see reduced taxes and what tax strategies will make sense for you this year, such as the best ways to time income and expenses.
Personal exemptions and the standard deduction
For individual taxpayers, the biggest changes of the Tax Cuts and Jobs Act are changes to personal exemptions and the standard deduction.
For 2017, taxpayers were able to claim a personal exemption of $4,050 for themselves, their spouse, and dependents. These exemptions could greatly impact families with children and other dependents, such as elderly parents. For 2018 through 2025, the TCJA suspends personal exemptions, but increases the child credit and allows a new family credit that may offset the deduction loss for some taxpayers.
Changes to the standard deduction may also help taxpayers make up for the loss of personal exemptions, but it may not help a lot of taxpayers who usually itemize their deductions.
The TCJA almost doubles the standard deductions for 2020 to $12,400 for singles and married filing separate, $18,650 for heads of households, and $24,800 for joint filers. Also, these amounts will be indexed for inflation through 2025 and after that, the deductions are scheduled to drop back to the amounts under pre-TCJA law.
Consider that these changes are temporary under the TCJA, Congress may take additional action to make them permanent.
The standard deduction versus itemized deductions
Taxpayers may choose to itemize certain deductions on Schedule A or take the standard deduction. If you’re able to itemize deductions and the total will be larger than the standard deduction, you will save tax, but it will make filing more complicated.
Taxpayers that typically itemized deductions in the past may be better off taking the standard deduction, because the larger standard deduction combined with the reduction or elimination of some itemized deductions will mean more taxpayers will find that the standard deduction exceeds their itemized deductions. This may have a significant impact on timing tax strategies.
Timing income and expenses
If you are in the position to time income and expenses, you can reduce your tax liability, and unnecessarily increase it if planning is disregarded. Taxpayers that are not subject to the AMT in the current year or the next year, deferring income to the next year and accelerating deductible expenses into the current year is usually a good idea because it will defer tax.
However, if the taxpayer expects to be in a higher tax bracket in the following year, the opposite approach could be beneficial: Accelerating income will allow more income to be taxed at the current year’s lower rate and deferring expenses will make the deductions more valuable because the deduction(s) save more tax when the taxpayer is subject to a higher tax rate.
No matter the reason behind the desire to time income and expenses, below are a few income items whose timing may be controlled:
Consulting and self-employment income
U.S. Treasury bill income
Retirement plan distributions, while considering early withdrawals and required minimum distributions
Here are a few potentially controllable expenses:
State/local income taxes
The TCJA makes timing income and deductions more challenging because some strategies that taxpayers have applied in the past could no longer make sense. For example, regarding the new cap limit on state and local tax, timing the tax payments may no longer be beneficial for some taxpayers.
Deduction for State and Local Taxes
The TCJA limits the deduction for state and local taxes (property tax and income tax or sales tax) to $10,000 ($5,000 for married filing separately). This will have a substantial impact on high income taxpayers with large state and local income taxes and/or property taxes.
Taxpayers can take an itemized deduction for either state and local income tax or state and local sales tax, but for most taxpayers, deducting state and local income taxes will provide the greatest benefit. However, deducting sales tax can be more valuable to taxpayers residing in states with no or low income tax or who purchase an expensive item (vehicle or boat).
Excluding major purchases, taxpayers do not have to keep receipts and track all the sales tax they paid during the year. The deduction can be determined using an IRS sales tax calculator that is based on your income and the sales tax rates in your locale in addition to the tax you paid on major purchases.
Health Care Breaks
In 2018, medical expenses not paid with tax-advantaged accounts or were reimbursable by insurance that exceed 7.5% of AGI, taxpayers can deduct the excess amount, but is scheduled to return to 10% at the beginning 2019.
Eligible medical expenses include:
Health insurance premiums
Long-term care insurance premiums
Medical and dental services
Mileage ($0.17 per mile in 2020)
Combining expenses into one year that would normally be spread over two years can save tax, especially when the floor is to change. If you combine medical procedures (without negatively affecting your health) into 2020 in order to take advantage of the 10% floor, you could potentially enjoy a larger deduction. Also, be aware that if one spouse has high medical expenses and a relatively lower AGI, filing a separate return may allow the spouse to exceed the AGI floor and deduct expenses that wouldn’t be deductible if they filed jointly.
(Expenses reimbursed by insurance and paid through a tax-advantaged account are not deductible)
Health Savings Account (HSA)
If the taxpayer is covered by a qualified high-deductible health plan, they can contribute pretax income to an employer-sponsored Health Savings Account (they can also make deductible contributions to an HSA by themselves) up to $3,550 for self-only coverage and $7,100 for family coverage in 2020. Also, for 2020, the taxpayer may contribute an additional $1,000 if they are age 55 or older.
HSAs can earn interest or be invested and grow tax-deferred, similar to an IRA. The withdrawals from the HSA for qualified medical expenses are tax-free, and the balance is carried over from year to year.
Flexible Spending Account (FSA)
Taxpayers can redirect pretax income to an employer-sponsored Flexible Spending Account up to an employer-determined limit that cannot exceed $2,750 for 2020. The plan pays or reimburses the taxpayer for qualified medical expenses, with some exceptions. Taxpayers have to make the election before the start of the plan year and what they don’t use by the end of the plan year, is usually lost. However, some plans might allow the taxpayer to roll over up to $500 to the next year or give you a 2.5 month grace period to incur expenses to use up the previous year’s contribution. Also, if the taxpayer has an HSA, the FSA is limited to funding certain “permitted” expenses (ex: child and dependent care expenses)
AMT (alternative minimum tax)
The top alternative minimum tax rate is 28% compared to the top ordinary-income tax rate of 37%, but AMT usually applies to a high income tax base.
The TCJA increases AMT exemptions for 2018 through 2025. This will mean fewer taxpayers will have to pay the AMT, but here are now fewer differences between what is deductible for AMT purposes and will still remain a threat for some high income taxpayers.
The tax payer should consider whether they are already likely to be subject to the AMT or the actions considered will trigger it. There are many deductions used to calculate regular tax are not allowed under the AMT and can trigger AMT tax liability. Some income items also may trigger or increase AMT liability such as:
Long-term capital gains and dividend income
Accelerated depreciation adjustments and related gain or loss differences when assets are sold
Tax-exempt interest on certain private-activity municipal bonds
In some situations, incentive stock option (ISO) exercises can trigger substantial AMT liability.
If a taxpayer has AMT in one year on deferral items (depreciation adjustments, passive activity adjustments, tax preference on ISO exercises, etc.), they may be entitled to a credit in the following year.
In addition to income tax, taxpayers are required to pay Social Security and Medicare taxes on earned income, such as salary, wages, and bonuses. The 12.4% Social Security tax applies to earned income up to a wage base of $137,700 for 2020. All earned income is subject to the 2.9% Medicare tax and both taxes are split equally between the employer an employee.
If the taxpayer is self-employed, the employment tax liability normally doubles, because they must pay the employer portion of these taxes. The employer portion of self-employment is 6.2% for Social Security tax and 1.45% for Medicare tax, which is deductible above the line.
A self-employed taxpayer may benefit from other above-the-line deductions as well, such as 100% of health insurance premiums for them self, their spouse, and their dependents, up to the net self-employment income. Taxpayers can also deduct contributions to a retirement plan and if eligible, an HSA. Self-employed taxpayers may be able to deduct home office expenses along with above-the-line deductions, which can be particularly valuable because they reduce AGI and depending on the specific deduction will affect certain additional taxes and the phase-outs of many tax breaks.
Additional 0.9% Medicare tax
Another employment tax that high income individuals must be aware of is the additional 0.9% Medicare tax as it applies to FICA wages and self-employment income that exceeds $200,000 per year or $250,000 for married filing joint and $125,000 for married filing separate.
There is no employer portion of the tax, so unlike the Social Security and Medicare tax, the additional Medicare tax does not double for the self-employed, but it does mean that no portion of the tax is deductible above the line against the taxpayer’s self-employment income.
If wages or self-employment income fluctuates significantly from year to year or the taxpayer is nearing the threshold for triggering the additional Medicare tax, income timing strategies may help them avoid or minimize the tax. For example, if the taxpayer is an employee, they may be able to time when they receive a bonus or you can defer or accelerate the exercise of stock options. If the taxpayer is self-employed, they may have the flexibility on when to purchase new equipment or invoice customers. Shareholder-employee taxpayers of an S corporation might save tax by adjusting how much they receive as salary versus distributions.
Also, employers are required to withhold the additional tax beginning in the pay period when the employee’s wages exceed $200,000 for the calendar year without regard to their filing status or income from other sources. The employer may withhold the tax even if you aren’t liable or they may not withhold the tax even though the taxpayer is liable.
If the taxpayer does not owe the tax, but the employer is withholding it, they can claim a credit on their tax return for the year the tax was withheld. If they do owe the tax but the employer isn’t withholding it, the taxpayer should consider filing a W-4 form to request additional income tax withholding, which can be used to cover the shortfall and avoid interest and penalties. Another option is to make estimated tax payments.
Employment Taxes for Owner-Employees
Partnerships and limited liability companies (LLCs)
Normally, all trade or business income that flows through to the taxpayer for income tax purposes is subject to self-employment taxes even if income isn’t actually distributed. Income may not be subject to self-employment taxes if the taxpayer is a limited partner or an LLC member whose ownership is equivalent to a limited partnership interest. The additional 0.9% Medicare tax on earned income or the 3.8% net investment income tax (NIIT) will also apply and can be complex to determine.
The only income received as salary is subject to employment taxes and, if applicable, the 0.9% Medicare tax. In order to reduce these taxes, the taxpayer may want to consider keeping their salary relatively, but not unreasonably low and increase your distributions of company income. Distributions normally are not taxed at the corporate level or subject to the 0.9% Medicare tax or 3.8% NIIT.
The only income receive as salary is subject to employment taxes and, if applicable, the 0.9% Medicare tax. It may be preferable to take more income as salary, which is deductible at the corporate level as opposed to dividends that are not deductible at the corporate level. However, dividend are still taxed at the shareholder level and could be subject to the 3.8% Net Investment Income Tax if the overall tax paid by both the corporation and the taxpayer would be less.
**Note** The IRS is cracking down on misclassification of corporate payments to shareholder employees, so be careful on your positions.
Estimated Payments and Withholding
Taxpayer can be subject to penalties if they do not pay enough tax during the year through estimated tax payments and withholding. In order to avoid penalties, estimated payments and withholding must equal at least 90% of the tax liability for the year or 100% of tax for the previous year. This changes to 110% if AGI for the previous year was $150,000 or more or $75,000 if married filing separately.
Under the annualized income installment method, a taxpayer with large variability in income by month due to bonuses, investment gains and losses, or seasonal income, can reduce the penalty using this method. Annualizing computes the tax based on income, gains, losses and deductions for each estimated tax period.
Estimate the Tax Liability and Increase Withholding
If at year end, determine what is underpaid and consider having a tax shortfall withheld from your salary or bonus by December 31. Withholding is considered to have been paid ratably throughout the year and this is often a better strategy than making up the difference with an increased quarterly tax payment that may still leave you exposed to penalties for earlier quarters.
Also, a taxpayer could incur interest and penalties if they’re subject to the additional 0.9% Medicare tax and it isn’t withheld from they pay and don’t make adequate estimated tax payments.