Rate Cuts, Deductions, AMT—these words are being tossed around a lot lately in the news headlines. Heated political opinions are flying back and forth claiming Trump policy will lead to tax cuts that benefit the rich or hurt the middle class or only help the top 1%. So, which is it? And how does all this affect you? We hear so much contradictory news, which may or may not be affected by political bias. Let’s look at the facts. Here’s your breakdown of the new Republican tax law, in plain English.
Income Tax Rates
One of Congress’s biggest selling points for the tax law is that it’s lowering income tax rates for Americans. That’s a good thing, right? But while tax rates are decreasing, know that tax is not always just about the rate. There are other factors that could actually make your 2018 tax bill increase. We’ll discuss those later. First, let’s get into how your income tax is calculated and what lowering the tax rate means.
For the sake of clarity, we’re just going to break down the basics. So… How is your income tax calculated?
Tax is calculated as a percentage of your taxable income, which is AGI minus certain deductions.
*Hang on… What’s AGI? AGI = Adjusted Gross Income. This includes income from your job wages, interest/dividends, short-term capital gains, + many other potential sources of income. (Note that we don’t discuss long-term capital gains tax on your investments, but this is still an important piece of your income tax. These rules aren’t changing under the new law, so we’ll explain more in future articles.)
Our income tax system is a progressive tax system, with income taxed at gradually increasing rates as your taxable income rises.
A headline we’re seeing a lot in the news is that the highest marginal tax rate declined. Meaning?
Your marginal tax rate is the % you pay on your last dollar of income (which increases the more income you earn). Beginning in 2018, the highest marginal rate drops from 39.6% to 37%. We refer to the income thresholds that delineate each corresponding tax rate as tax brackets. The 2018 tax brackets for those filing as an individual or married filing jointly are the following:
Let’s look at an example. Say you’re a single person and your gross income (the total amount you make in a year) is $92,000. If you elect the standard deduction (more on that later), this means your taxable income is $80,000 in 2018. With these new tax brackets, the first $9,525 of your taxable income is taxed at 10%, the next $29,175 ($38,700 – $9,525) is taxed at 12%, and the last $41,300 of taxable your income ($80,000 – $38,700) is taxed at 22%. Since that’s a lot to say in one sentence, most people will quote their highest marginal rate—in this case 22%—as their tax rate, when really, if you do the math, the percentage of their income that they pay in taxes will be a bit lower:
Under the new tax plan, marginal tax rates for each bracket are a few %’s lower, and it takes more income to get you into the next highest tax bracket. While lower income tax rates are a good thing for your family’s tax bill, you could still end up paying more in taxes next year. Here’s why…
The new law reduces itemized deductions. Let’s go through a high level of how this works.
Deduction = an expense that is subtracted from income. If you remember from the first section: AGI – Tax Deductions = your Taxable Income. Taxes are calculated as a % of your taxable income, and as we saw earlier that % rises with the more income you earn. Less income means a lower tax bill—so the more deductions, the better!
There are two types of deductions: Standard Deductions and Itemized Deductions. You get to choose the higher of the two (not both).
The Standard Deduction is a single amount you get to subtract from your income if you aren’t “itemizing” (taking itemized deductions). This amount is standard, meaning that it is the same amount for everyone who doesn’t itemize.
- The new tax bill nearly doubles the standard deduction:
$6,350 -> $12,000 if you’re single, $12,700 -> $24,000 if you’re married.
Itemized Deductions are specific expenses throughout the year that the government lets you subtract from your AGI. You add up all of your itemized deductions to get the total amount you get to deduct (subtract). The new law is changing the limits on certain itemized deductions:
- You can now only deduct up to $10,000 of your combined state property and income taxes. This deduction previously had no top limit, and will affect a lot of families who live in high-tax states like NY, CT, and NJ.
- If you’re purchasing a new home, you can now only deduct interest on your home mortgage payments for up to $750,000 of your mortgage (as opposed to the previous $1 million limit).
- Homeowners can no longer deduct interest they pay on home-equity loans (previously deductible up to a $100,000 loan).
- You can still deduct charitable donations, and can actually deduct a bit more than previously (up to 60% of your AGI as opposed to 50%).
- You can now deduct medical expenses that exceed 7.5% of your AGI (as opposed to 10%), but beginning in 2019 the threshold returns to 10%.
- You can no longer deduct certain “miscellaneous expenses” that exceed 2% of your AGI, including tax preparation and investment management fees.
There also used to be something called a Personal Exemption. Like a deduction, exemptions are subtracted from your AGI to get to your taxable income. However, all personal exemptions (of $4,050 each for tax filer; spouse; and dependents under age 19, or age 24 if a student) are completely removed under the new law. (Note that these exemptions were phased out for higher income earners, meaning you wouldn’t have gotten them anyway if your AGI was greater than $261,500 for single tax filers or $313,800 for those married filing jointly.)
The decrease in itemized deductions and elimination of personal exemptions could make your tax bill higher starting in 2018, even with lower income tax rates. This will likely have much more of a negative impact on your tax bill if you live in a high-tax state like NY, NJ, CT, or CA.
Okay, so what’s AMT got to do with it?
AMT = Alternative Minimum Tax. It’s a parallel way you have to calculate your income taxes, in addition to the regular way we discussed above, if your income exceeds a certain threshold. Sometimes your regular tax calculation is less because you have so many itemized deductions (e.g. deductions for mortgage interest, state income and property tax, investment advisory fees, etc.) to subtract from your income; the government uses AMT to make sure everyone is paying their fair share. The key takeaway with AMT is: if you’re “in AMT,” that means that your AMT calculation is higher than your regular tax calculation, and that you have to pay that higher AMT amount. Many middle- to upper-class Americans who itemize have to worry about calculating and potentially paying additional tax through AMT.
The new tax law is decreasing the number of taxpayers who have to calculate AMT by raising the income threshold, and also decreasing how much additional tax people owe for those who do end up in AMT by increasing the exemption phaseout threshold. (This means that more people will get the exemption, which is an amount you get to subtract from your AMT income number to reduce your AMT taxable income.) Reducing the impact of AMT makes sense with the decrease in itemized deductions under the new law, and helps to simplify tax calculations.
What Does All This Mean for Me?
Reducing AMT, decreasing itemized deductions, eliminating personal exemptions, and increasing the standard deduction are meant to simplify tax calculations for many Americans. The net result is moving us towards a flatter tax at lower marginal rates, as more taxpayers elect the increased standard deduction. However, if people are no longer itemizing deductions, that weakens previous tax incentives for things like charitable contributions and new home purchases. That said, itemized deductions can still significantly reduce taxable income for many higher income earners, depending on your expense list.
High-income, charitably-inclined taxpayers will likely see a net positive effect on their tax bill as the reduction in allowable itemized deductions is offset by more charitable deductions and the reduction in income tax rates. Lower income-earners who previously elected the standard deduction are likely to see a net positive effect on their tax bill as well with the increased standard deduction and reduced marginal rates. But, for the many Americans between, it’s going to depend on your individual situation. Lower income tax rates may or may not be negated by higher taxable incomes that result from the reduction of itemized deductions and the elimination of personal exemptions. Those who have children going through college and high state income and property taxes will likely see greater negative effects, while middle- and upper-class families previously subject to AMT may see less change with a cut in additional taxes owed from AMT. However, keep in mind that these are generalities. There are so many factors involved in your tax calculation that you need to sit down with your financial advisor and accountant to discuss your individual situation and run the numbers in order to know the true impact of the tax law changes on your family’s tax bill.
So, your tax bill in 2018 could be lower, higher, or the positive and negative changes could cancel each other out. The individual income tax changes we discussed – personal income tax rate cuts paired with decreased itemized deductions, increased standard deduction, and no personal exemptions – are likely to actually have a negative net effect for a lot of Americans who itemize, have families, and live in high income and property tax states. But don’t panic—these changes are temporary, and only affect tax years 2018 through 2025. Beginning in 2026, the personal income tax code will return to its original state, unless a future Congress passes a new bill to extend these provisions.
There’s also another major change we haven’t touched on yet: the new law more than doubles the estate tax exemption amount. This is a positive change for high net worth individuals and is also temporary from 2018-2025. The exemption, previously $5.49 million per individual and $10.98 million for married couples who elect portability, is now $11.2 million per individual and $22.4 million for married couples who elect portability. Look out for our next quarterly newsletter for more on estate tax law changes and why you may need to update your estate plan.
Talk to Your Advisor
The limited timeline and future uncertainty surrounding the new tax law is important to keep in mind when reviewing your tax situation and long-term financial plan with your accountant and wealth advisor. During this time of change, it’s important to optimize your tax efficiency and even more important to manage your portfolio in light of the new tax law. Inaction could cause more negative consequences than necessary. As always, we’re here to help you stay informed and prepared to protect your current and future financial well-being.
We hope this article gives clarity on the must-know basics of an extremely complex law that affects virtually all U.S. taxpayers. As always, don’t hesitate to reach out to your Wealth Advisor with questions, or send us an email with feedback or topic suggestions for next quarter’s Women at the Table newsletter at firstname.lastname@example.org or email@example.com.