16 Dec 2016 How Tax Reform Might Impact Your Year-End Tax Planning
Odds are quite good that our tax code is in for major changes next year and they will be favorable for most people. President-Elect Trump’s tax plan and the Republican House plan are similar in enough areas to factor them into this year’s-end tax planning.
With the help of several of our fellow professional advisors, we’ve put together a summary of possible tax code changes as well as some specific strategies to consider this year. Broadly speaking, if your tax bracket indicates lower taxes next year, it pays to defer as much income until next year as possible and maximize deductions this year.
Michael Kitces points out that deductions are one of the key areas of difference in the two plans. The House GOP plan does away with most deductions except mortgage and charitable. Trump’s plan keeps deductions in place, but adds caps of $100,000 for individuals and $200,000 for married couples. Claiming as many deductions this year as possible makes sense if the GOP plan wins out, and making large charitable gifts this year makes sense if Mr. Trump’s plan wins. Kitces points out that Qualified Charitable Distributions from IRAs might be used to bridge a potential deduction gap, if the caps become law. A QCD is a direct transfer of funds from your IRA custodian made payable to a qualified charity. Benefits include the gift to charity as well as a reduction in your taxable income by the amount donated.
Current tax law has seven brackets ranging from 10% to 39.6%. Trump and House Republicans want to simplify the code by collapsing it to just 3 brackets – 12%, 25%, and 33%.
The charts below, prepared by Kitces, compare this year’s brackets to next year’s potential tax brackets to provide a handy reference, depending upon where you fall in taxable income, to accelerate or defer income this year. The first chart is for married couples and the second one for individuals.
If your taxable income falls within what Kitces calls “green zones,” indicating where taxes will be potentially lower next year, you may want to defer income and push it into 2017’s possibly lower rates next year. The improvement is a whopping 6.6% for those in the highest income bracket of 39.6%.
Kitces notes that Trump’s plan eliminates the “marriage penalty” (dual incomes currently face higher tax rates than they would filing as individuals) by making the married couple brackets exactly double the individual brackets. He says “For married couples, the good news is that 2017 tax reform is likely to be favorable at virtually any/every income level. The 15% bracket would drop to 12%, the 28% bracket would drop to 25%, and the 35% and 39.6% rates would drop to a maximum of “just” 33%”
Notice in the figure above that the large red bar reveals an increase in taxes next year for individuals with taxable income between roughly $112,000 and $192,000. Much of the 28% bracket is replaced by the new 33% rate, effectively increasing taxes for a significant number of individuals, if not adjusted in compromises.
Here are some ideas from Kitces for deferring income into next year:
- Small business owners and consultants who have some income flexibility might push some payments into next year
- Retirees taking withdrawals from IRAs (beyond those required) might wait until next year
- Those reaching 70 ½ this year have until April 15th of next year to begin taking withdrawals. It pays to consider whether taking both this year’s and next year’s required distributions next year would be beneficial.
- It would make sense for those in the green zone considering Roth conversions to defer to next year. But those who have some remaining 15% bracket this year might want to do a partial conversion this year.
Capital Gains and Tax-Loss Harvesting
- Top bracket filers paying capital gains of 23.8% (which includes the 3.8% Medicare surtax) will want to harvest losses this year and defer gain until next.
- Low bracket filers will want to harvest capital gains at the 0% rate.
- Those in the 15% capital gains bracket with mounting gains may want to harvest now because Trump’s plan eliminates the 18.5% tier and replaces it with 20%.
Kitces’ chart below demonstrates how much both Mr. Trump’s and the House’s plans reduce capital gains and at what income levels.
For two significant reasons, it may make sense to accelerate deductions into this year rather than next. Tax rates will likely be lower and tax reform by both the House and Mr. Trump may eliminate or substantially reduce most commonplace deductions.
Here are some tips from Kitces:
- Maximize any planned charitable contributions
- Small business owners accelerate improvement, equipment, and supply purchases (likely on sale) to take advantage of the 6.6% drop in the top rate from 39.6% to 33%.
- Pay remaining estimated state income taxes as well as any additional tax expected.
- Pay large medical expenses this year.
- President-Elect Trump’s proposal caps itemized deductions at 100K and 200K for individuals and marrieds, while the House GOP plan eliminates virtually all itemized deductions except for charitable and mortgage interest.
Kitces points out that Trump’s proposed cap could especially problematic for those considering large charitable giving. While it is likely that there will be special provision for charitable giving as the two plans are reconciled, it is still best to plan for the worse, if timing of the gift is the only question.
It seems advisable that anyone in the top brackets considering major contributions to a charity or charities in the coming years should consider funding a Donor Advised Fund this year rather than next. Kitces says the transfer will of course be subject to this year’s tax code “where a DAF is a “50% charity” (deduction for charitable contributions generally can’t be more than 50% of adjusted gross income (AGI), but in some cases 20% and 30% limits may apply) but even a large contribution with a partial carry-forward may fare better than making the whole contribution in the future with a deduction cap.”
Year-End Retirement Planning for Individuals
Stephen Register of Thomas Judy & Tucker CPAs (“TJT”) offers some helpful tips to IRA owners. As long as money stays in your IRA, taxes are deferred. But you may want or need to consider alternative strategies, based on circumstances. If you’re retired or have unexpected expenses, the IRA can be an excellent source of funds.
Or, if you expect your traditional IRA to be extremely large by the time you reach age 70 1/2, when required minimum distributions begin, you may want to consider spending from it sooner. If other income does not take you into higher brackets, you might want to withdraw enough to fill the lower brackets. If your tax situation does not permit you to deduct management fees, you might consider paying the management fee for your IRA paid within the IRA. You cannot, however, pay management fees for other accounts with your IRA.
Year-End Small-Business Planning
John Broadfoot of TJT reminds small business owners that they may confidently purchase equipment and software this year. As long as total outlays don’t top $2.01 million, expenses up to $500,000 can be deducted for 2016 rather than spread over several years. To qualify for the IRC Section 179 tax break, the equipment or software must be purchased, financed or leased, and placed into service by December 31. The deduction will equal the full purchase price.
If you have been thinking about establishing a company 401(k) plan for 2016, December 31st is the deadline, assuming your company uses a calendar year. Employee contributions for 2016 must be withheld from 2016 paychecks and must be sent to the relevant financial firm as soon as possible. Employer contributions, deductible for 2016, can be made up to the company’s tax return due date, including extensions.
A variation of the basic 401(k) is often known as the solo 401(k) or the individual 401(k). These plans are open only to business owners and their spouses who are employed by the company. For 2016, the maximum contribution to a solo 401(k) is $53,000 per participant, if certain conditions are met, or $59,000 for those age 50 or older. Basic 401(k) plans have contribution limits of $18,000 or $24,000 before any employer match.
Along with lowering the corporate income tax rate from its current max of 35% to a new maximum of 15%, Trump is considering doing the same for small business owners who file Sub-chapter S on their own tax returns.
Please stay tuned as we watch the development of future legislation around the tax code, and in the meantime don’t hesitate to get in touch with us if you have any questions about the impact of all this on your financial plan.