If you’re wondering how the new tax law will affect you, you aren’t alone. In short, it means that your tax strategy is likely to change. I wrote about the possible effects of the Tax Reform and Jobs Act of 2017 for California residents last month before the final bill was passed. The punchline? If you live in a high income-tax state, the lower brackets do not help out as much as you would think. SALT (state and local income tax) deductions are a significant federal deduction for many Californians and others that live in high state income tax areas.
However, CA state lawmakers may have a way for its residents to avoid the $10,000 SALT deduction limit, which is now part of the new federal tax law. See below where I discuss this further.
I also wanted to provide an overview of what this new tax law means. But before we jump into the overview, it is important to point out the massive federal tax revenue hit this bill will create. According to the nonpartisan Joint Committee on Taxation, there will be an estimated $1.46 trillion revenue reduction over the next 10 years. Furthermore, many of these tax cuts are temporary while providing a major tax cut for wealthy individuals who live in low/no income tax states. How this will affect the greater economy going forward remains to be seen. Though, I would assume the economic benefits promised are exaggerated at best.
Eric Sussman, a finance professor at UCLA Anderson and one of my favorite lecturers, wrote on this topic where he provided an excellent argument as to why this will create a short-term boost to the markets but a long-term drag to the overall economy.
Tax Reform Overview
| 2018 Federal Income Tax Brackets | ||
| Tax Rate | Single | Married, Filing Jointly |
| 10% | Up to $9,525 | Up to $19,050 |
| 12% | $9,526-$38,700 | $19,051-$77,400 |
| 22% | $38,701-$82,500 | $77,401-$165,000 |
| 24% | $82,501-$157,500 | $165,001-$315,000 |
| 32% | $157,501-$200,000 | $315,001-$400,000 |
| 35% | $200,001-$500,000 | $400,001-$600,000 |
| 37% | Over $500,000 | Over $600,000 |
Standard Deduction. The standard deduction amount has increased A LOT. The new amounts are as follows:
– Married Filing Jointly/Surviving Spouse: $24,000
– Head of Household: $18,000
– Single: $12,000
– Married Filing Separately: $12,000
State and Local Income Tax (SALT). State and local income and property taxes will be deductible up to a combined $10,000 cap. This means that most individuals will likely be filing with the standard deduction.
Alternative Minimum Tax. The AMT exemption amount will increase to $70,300 for single filers and $109,400 for MFJ and will phase out for those filers at $500,000 and $1MM respectively.
Capital Gains Tax Rate. There is no change to the tax law. For most investors, the long-term capital gains rate will be 0%, 15%, or 20%.
Estate Tax. The 40% estate tax rate would apply to estates valued at $11.2MM for a single filer or $22.4MM for couples.
Corporate Tax. Over a year ago, when President Trump was just elected president, I wrote about the possible effect on stock prices a lower corporate tax rate would have. I suspected the tax rate would be closer to 20%, rather than the 15% he first proposed. I was very close to the actual rate, which is now 21%. Additionally, the corporate AMT is now repealed. A reason why the stock market has rallied for the past 14 months is partially due to the probability of lower corporate taxes. I plan to write about this some more in the future.
Small Businesses and Pass-Through Entities. Small business owners can now take a 20% deduction on their pass-through business entity, including sole proprietors, LLCs, C-Corps, S-Corps, etc. What does this mean? “Business income that passes through to an individual from a pass-through entity and income attributable to a sole proprietorship will be taxed at individual tax rates less a deduction of up to 20% to bring the rate lower. (Forbes) Sound confusing? It is. There are limits and restrictions, and it requires a bit more study to understand it better.
529 College Savings Plans. Traditionally, 529s could only be used for qualified higher-education expenses (tuition, books, etc.). Now, account holders can use 529 funds (up to $10,000 per year) towards elementary or secondary public, private, or religious school tuition.
New Way To Avoid SALT Deductions?
As mentioned earlier, one of the biggest consequential measures for California residents is the $10,000 federal cap on SALT (state and local income tax) deductions. The average SALT deduction claimed by Californians is over $22,000, well above the cap.
Last week, Kevin de Leon proposed a workaround for the SALT cap. The bill would allow its filers to make a charitable contribution to the state in exchange for a tax credit. The tax filer would deduct that contribution on their federal return since the new law doesn’t cap deductible charitable contributions unless it exceeds 60% of your adjusted gross income.
Example: Let’s assume that you had to pay $50,000 in state income and property taxes in 2018. You may only deduct $10,000 of that on your federal return. To help you preserve the deduction for the remaining $40,000, California would let you make a $40,000 charitable contribution to the state in exchange for a $40,000 tax credit on your CA state tax return.
New York, New Jersey, Illinois, and other high income-tax states are also considering similar strategies. But are charitable contributions to states permitted under the Internal Revenue Code? Yes. In fact, there is already a precedent of the IRS and the courts supporting the full deductibility of charitable contributions to states in other circumstances. So watch out; this may become a real law sooner rather than later.
Bull Oak offers transparent San Diego financial services. We make sure clients seeking a financial plan in San Diego are well educated on current events and how the political climate, new laws, and tax changes will impact their finances.
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