Top Ways Tax Reform Affects Individuals, Estates and Trusts
Individual taxpayers (defined as U.S. citizens and legal residents) at every income level will feel the impact of the Tax Cuts and Jobs Act (“TCJA”) – some more than others. However, high-net-worth individuals may have the most to gain and the most to plan for, thanks in no small part to the top tax rate being reduced and the estate and gift tax exclusion nearly doubling under this new legislation.
Whatever your own tax situation may be, knowing the top ways tax reform affects individuals, estates and trusts can help you to make the most of new tax savings and minimize negative impacts.
Please note that when you see the word “suspended” relating to some of the changes, it is because the law was written to comply with Congressional budget requirements. Therefore, many deductions and changes within the TCJA are only suspended until after December 31, 2025.
How Do the Individual Tax Changes Affect You?
Income tax rates. The TCJA retains seven rate brackets. However, the top rate dropped from 39.6 percent to 37 percent. The lowest rate remains at 10 percent. The income thresholds that are applied to each tax rate changed, too. The qualified dividends and long-term capital gain tax rate remained unchanged at 0 percent, 15 percent and 20 percent.
Standard deductions and exemptions. The standard deduction has been increased to $12,000 for single filers, widows and those who are married but filing separately; $24,000 for those who are married filing jointly (“MFJ”); and $18,000 for head of household filers. The new law suspended the personal exemption deduction through 2025. The increased standard deduction is a trade-off that’s meant to make up for the suspension of personal exemptions.
Mortgage interest and SALT deductions. Both the home mortgage interest and the state and local tax (“SALT”) deductions were significant targets during the negotiations between the House and Senate. The mortgage interest deduction is now limited to up to $750,000 of the amount you borrowed to pay for your home. For property purchased on or before December 15, 2017, the previous mortgage limit of $1 million still applies. Additionally, home equity indebtedness can no longer be claimed as a deduction.
State and local taxes are now limited to a deduction of no more than $10,000 ($5,000 in the case of a married individual filing a separate return). In areas with high property taxes, such as New Jersey, New York and California, to name a few, people are understandably upset at the loss of this deduction. Legal battles are brewing over the matter, so stay tuned.
Medical expense deduction. The medical expense deduction continues unchanged in 2018. Once your total medical expenses are equal to 7.5 percent of your adjusted gross income (“AGI”), you can claim a deduction for any medical expenses over that 7.5 percent threshold. After 2018, the limitation on the medical expense deduction increases to 10 percent of AGI, which is the level of the deduction prior to the Affordable Care Act.
Charitable contributions. On a positive note, the deduction limit on cash charitable contributions was increased from 50 percent of a taxpayer’s contribution base to 60 percent. However, if you spend money on college and university athletic events, be aware that you can no longer receive a deduction for the 80 percent of your ticket price that used to be labeled as a contribution.
Section 529 plans. Changes to section 529 plans now allow for expanded use of these funds with certain limits. Distributions from 529 plans can be used for elementary and high school tuition (kindergarten through 12th grade). However, make sure to review your state law 529 plan rules to determine if your state follows these new Federal-level changes.
Alternative minimum tax (“AMT”). The AMT has slowly been encroaching on many upper middle-class Americans since its enactment in 1982, exacerbated by the fact that Congress has failed to index the AMT exemption for inflation. While Congress did not eliminate the individual AMT all together (like it did with the corporate AMT), the exemptions and phase-outs were significantly increased, making fewer taxpayers subject to the AMT. The AMT exemptions are $70,300 (single) and $109,400 (MFJ). The phase-out thresholds are $500,000 (single) and $1 million (MFJ).
Child tax credit. For 2018 through the end of 2025, the child tax credit (“CTC”) has increased from $1,000 to $2,000. The threshold limitations have been raised to $400,000 for MFJ or $200,000 for any other filing type. The CTC’s refundable portion is limited to $1,400.
“Kiddie tax.” The kiddie tax applies to the unearned income of a child who is under age 19 or under age 24 if he or she is a full-time student. This tax definitely got simpler with the tax law changes. For one thing, the computations got easier. The tax is no longer tied to the parent’s rate of tax or any other sibling’s income. For 2018, the kiddie tax is based solely on trust income tax rates. Kiddie tax income levels hit the top rate of 37 percent at $12,500 of taxable income.
Miscellaneous itemized deductions. There are many miscellaneous itemized deductions that have been suspended. Some of these deductions include tax preparation fees, trade or business expenses incurred as an employee, and investment management fees. Moving expenses and reimbursements remain available to active duty Armed Services members but are unavailable to anyone else. Personal casualty losses are only allowed if they occur within a presidentially declared disaster area. The ability to deduct alimony payments and the requirement for alimony recipients to include those payments in income continue until the end of 2018. However, for divorce or separation instruments decreed or executed after December 31, 2018, the deduction and income-inclusion requirements are suspended. Pre-2019 separation agreements that are modified may become subject to these restrictions.
Changes That DID NOT Happen
Of all the tax provisions the TCJA changes, just as significant are the tax provisions that didn’t make their way into the final law. The ability to limit the gain on the sale of your personal residence remains, as well as the ability to specifically identify shares of stock to be sold. Both provisions faced significant potential changes, which did not materialize in the final bill. Provisions such as the adoption tax credit, the student loan interest deduction, and employer tuition assistance, to name a few, remain in place.
Estate Tax Impact
Some high-net-worth individuals will benefit from the fact that the tax exclusion applied to assets transferred at death or during life by a U.S. citizen or resident increases from $5.49 million in 2017 to $11.18 million in 2018. However, the increased exclusion amount is set to expire at the end of 2025, if it isn’t renewed or made permanent by lawmakers before then.
In the meantime, the increased exclusion limit means there are new planning opportunities available. Key areas of estate planning should include:
- Making a plan to take advantage of the additional exclusion amount based on your goals and objectives
- Creating an estate plan even when you don’t currently have a taxable estate in order to incorporate:
- Asset protection strategies to ward off depletion of assets from divorce, lawsuits, malpractice, or potential problems within the family, such as addiction, money mismanagement, family quarrels, and other potential financial issues
- Probate avoidance and privacy protection
- Shifting future appreciation of assets to future generations
- Protections for your assets by specifying a purpose for them
- Creating strategies to transfer wealth while maintaining flexibility to control investment decisions and future beneficiaries
- Developing charitable planning strategies that include maximizing charitable deductions and minimizing income tax exposure
Income Tax Impact on Trusts and Estates
Under the TCJA, the tax rates for trust and estate income apply to smaller thresholds of income when compared to the newly set tax rates for individuals, such that the top trust or estate tax rate is reached much more quickly. For example, an individual with taxable income of $25,000 would be subject to a top tax rate of 12 percent. However, a trust or an estate during administration with the same level of income is subject to a top tax rate of 37 percent. Fortunately, some of the planning opportunities mentioned in this tax alert can be used to minimize this tax impact.
The income tax deductions available to a trust or an estate generally follow the individual itemized deduction rules in the TCJA. As a result, SALT deductions are limited to $10,000. Certain deductions previously allowed at 100 percent if they are unique to or otherwise incurred solely because of the existence of the trust or the estate are believed to still be deductible. However, future guidance is needed for clarification.
Thanks to changes to section 199A deductions, individuals may be able to reduce the tax rate on their business income from pass-throughs from 37 percent to 29.6 percent. The new section 199A deduction is also one of the more complex deductions in the tax code. It applies to both trusts and individuals. In a situation where an individual’s business income may be limited or doesn’t qualify for the deduction, there may be a way to move some of the business interest into a trust in order to qualify for more of this new deduction. There are too many variables to list in this article, but restructuring pass-through income through the use of non-grantor trusts may be an opportunity worth looking into.
Now that SALT deductions are capped at $10,000, individuals who own second homes in areas with high property taxes may want to look at options for obtaining additional deductions and accomplishing estate planning at the same time. For example, take someone who has a second home with high property taxes and is limited in what he or she can claim on a Schedule A. That individual could move that second home into a limited liability corporation (“LLC”). Then, he or she can gift interest in the LLC into separate trusts for the benefit of any children and future generations. Then, he or she can also move income producing marketable securities into these trusts in order to deduct the real estate taxes from the second home in the LLC. The asset (i.e., the second home) is no longer part of the parent’s estate. It is held in trust for the next generation in an asset-protected manner while obtaining the real estate tax deduction.
Funding a 529 plan is an excellent way to transfer wealth to future generations, because the lifetime gift exclusion of $11.18 million isn’t reduced by the amount you put into one of these plans. For 2018, the maximum amount an individual can put into a 529 plan is $75,000, allocated over a five-year period. A married couple can fund a 529 plan with up to $150,000. So, for example, consider grandparents with a large estate and six grandchildren. The grandparents could transfer $900,000 of wealth for educational purposes to their six grandchildren without any gift tax implications (AKA $11.18 million of their estate is still exempt from the estate tax). BONUS: The funds grow tax deferred (and potentially tax free when used for education) for future generations. Beware: Some states may not follow the Federal change relating to distribution for K-12 schooling, which would result in the distribution being taxable in that particular state.
Individuals with existing trust and estate plans should review them to ensure that the change in the exclusion amount doesn’t negate or disrupt their initial estate plans. Many pre-2018 estate plans include disposition provisions that maximize the current exclusion amount to a trust for future generations. That means that these original estate plans are most likely not making the most of the new estate plan provisions.
Next Action Steps
For help navigating the new tax provisions for individuals, estates and trusts in the TCJA, reach out to Mike Kirkman, CPA, National Leader of Estate, Gift and Trust Services, and his team to start the conversation. Whatever questions you have, big or small, they’re happy to help find the best solutions for your unique situation.