Recent years have introduced the most comprehensive change to tax law in generations. As individuals and business entities came to find, many familiar paths available have reached a new crossroads and unknown territory.
While recent tax reform simplified some aspects of tax planning, other areas are new and complex. Regardless of this trade-off, those who learn to embrace the change and adjust accordingly may realize a significant advantage over those who don’t.
What Did Tax Reform Accomplish?
Despite volatility in tax rates, the basic income tax landscape for individuals, trusts and estates has remained constant. However, the passage of the Tax Cuts and Jobs Act (TCJA) significantly altered the tax planning landscape. It has prompted tax advisers and taxpayers alike to pause and rethink how to navigate this new tax environment.
Some elements remain unchanged. Others may appear similar but small differences upon closer inspection will reveal small shifts in application. Some examples include the increased ability to offset income with charitable contributions or the decreased deduction of state and local taxes (SALT). Finally, you may begin to notice missing elements from the tax code altogether. These elements include personal exemptions, miscellaneous itemized deductions, and alimony.
When Congress debated changing the tax code in 2017, it was intended to simplify the process for the individual taxpayer. By making itemized deductions harder to claim and instead opting for a larger standard deduction, far fewer individuals would qualify for itemizing and need to suffer the headache of tax return preparation.
While the full effects of tax reform will not be known for some time, the aggregate population projects to pay less over the life of the tax changes. As with all policy changes, there are winners and losers. Here are some of the major changes tax reform has brought and who’s likely impacted most.
4 Ways Tax Reform Changed Individuals’ Tax Situations
1. Tax Reform Resulted in Lowered Individual Income Tax Rates
America uses a progressive tax system for income taxes. This means as a taxpayer makes more income and exceeds certain thresholds, the amount of tax paid on an additional dollar of income increases.
For example, if you ignore the effects of the standard deduction and you made $30,000 as a single filer in 2018, you would pay 10% on the first $9,700 ($970) and 12% on the remaining $20,300 ($30,000 – $9,700) or $2,436. You would not pay 12% on the entire $30,000. The new tax law changed two things about the individual tax rates in 2018:
Tax rate modifications:
The tax law kept the seven existing federal income tax brackets though it lowered the tax rate of every bracket except for two. This reduces the amount of money you pay on each additional dollar of income by varying amounts.
Notably, the highest tax bracket from prior to tax reform was 39.6 percent. It is now 37 percent for income over $500,000 for single filers and $600,000 for married filers.
Different taxable income ranges:
The law also changed the income brackets for tax filers. Income ranges applicable to each tax rate either widened or narrowed, depending on the level of income.
On the low end, the bottom two brackets remained unchanged. Then, on the upper end, the highest tax rate (37%) doesn’t begin until a single taxpayer has earned $500,001 of taxable income as opposed to $426,701 under the old tax brackets.
Also, the TCJA retains the 20 percent special tax rate for long-term capital gains and qualified dividend income (with an advantageous passive income tax rate). The 3.8 percent tax on certain levels of net investment income. Also, the 0.9 percent FICA high income on certain level of earned income that were in effect under prior law.
2. How did Tax Reform Change the Standard Deduction?
Tax reform changed the nature of filing your tax return. It increased the standard deduction and making most taxpayers ineligible for itemizing their tax deductions. Now, fewer people qualify for taking the most common tax deductions. Therefore, most simply use the standard deduction instead of itemizing their tax deductions.
For single filers, the standard deduction nearly doubled. It went from $6,350 in 2017 to $12,000 in 2018 to $12,200 in 2019. Married, filing jointly filers saw their standard deduction go from $12,700 to $24,000 in 2018 to $24,400 in 2019. Further, the elderly or blind receive an additional standard deduction worth $1,650 in 2019 (single vs. $1,300 married) vs $1,600 in 2018.
3. What did Tax Reform Change for Homeowners?
Tax reform changed the treatment of deductions many claim related to homeownership. The higher standard deduction created not only a higher hurdle to qualify for the mortgage interest deduction. But, tax reform also lowered the levels of mortgage principal and associated interest expense that qualifies for deductibility.
Tax reform has made it less-advantageous to be a homeowner from a tax point of view. If you are debating between purchasing a condo or renting an apartment, these changes may have tipped the scale in favor of renting. This depends on your location. Thankfully, accelerated depreciation remained unchanged or improved and can still offset rental income from taxation.
In the past, you could deduct the mortgage interest associated with the first $1 million of your mortgage. You could also deduct the interest associated with the first $100,000 of a home equity loan (assuming the funds are used for qualifying home improvements). Tax reform changed this only to allow the interest expense associated with the first $750,000 for taxpayers who are married and file jointly, and $375,000 for single taxpayers. If you originated a mortgage in 2018 above this threshold, it gives you the incentive to pay off your mortgage faster.
It is worth noting this limit only applies to new loans originated after 2017. Pre-existing mortgages are grandfathered under the old limits. Given the higher watermarks of these amounts, higher-income individuals located in non-coastal areas and those in high cost of living areas are disproportionately impacted.
4. State and Local Taxes
A higher standard deduction, lower tax rates and bigger brackets helped many pay less in taxes in 2018. However, not everyone was so lucky. Many who lived in high cost-of-living areas paid a considerable amount of money each year in state and local taxes (SALT). Also, a new cap impacted them disproportionately.
In 2018, there was a $10,000 per household cap placed on the amount of SALT taxes that can be deducted from federal taxable income. Homeowners living in these higher cost areas were hit hardest. Many deducted real estate and property taxes as well as other applicable state and local income taxes. This new cap limited their ability to do so. The only way that high cost of living homeowners can come out ahead is if their incomes fell into lower brackets. This would see more of their incomes fall into lower rates.
It is important to understand how all of the changes interact and impact your goals and circumstances should you wish to pursue financial independence.