Last December, Republicans in Washington passed the biggest changes to the U.S. tax code in decades, and while most of the really significant alterations were made for businesses (hello, corporate tax cuts!), there are plenty that will directly affect what ordinary Americans will pay to Uncle Sam. Based on analyses done at the time, a large fraction of the middle class will find their annual tax bills shrinking a bit, but another significant share is on course to owe a lot more. As we approach the end of 2018, Motley Fool Answers hosts Alison Southwick and Robert Brokamp want to help you get a jump on tax season, so for this episode of the podcast, they've brought an expert into the studio: Megan Brinsfield of Motley Fool Wealth Management.
In this segment, they talk about itemizing, the new higher standard deduction, and the raft of deductions and exemptions that Congress reduced or eliminated. They also reflect on the failed attempts by high-tax states to help their residents avoid the pain of losing the ability to deduct state and local taxes, and consider what the expansion of the pass-through deduction will mean for the growing population of self-employed Americans.
A full transcript follows the video.
This video was recorded on Oct. 16, 2018.
Robert Brokamp: It's October, which means we're 10 months into the Tax Cuts and Jobs Act...
Alison Southwick: Yay! You said that with such enthusiasm.
Brokamp: Tax Cuts and Jobs Act! Yay! Anyway, the newest tax law that was passed at the end of 2017. Hopefully you're among the majority of Americans who have, indeed, seen a lower tax bill likely around a few hundred dollars to maybe a couple of thousand dollars if you're a typical American household. Unfortunately, there are households that will end up having to pay more tax due to a loss of some deductions which we'll talk about in a little bit. But regardless of your situation, there may be some steps you can still take to reduce this year's tax bill before 2019 rolls around, and here to help us discuss these strategies is our resident tax expert, Megan Brinsfield of Motley Fool Wealth Management...
Southwick: A sister company of The Motley Fool.
Brokamp: Yeah, there you go! I thought before we talk about the tax tips, maybe we should just hit, as a reminder, some of the highlights of the new tax law. First of all, there's still seven tax brackets, but lower overall rates except for the bottom two, and it takes more income to move up to a higher tax bracket. So in that sense, most people probably will be paying less taxes.
The big thing is a higher standard deduction -- $12,000 for singles and $24,000 for married folks -- which will probably drop the percentage of people who itemize from one-third in 2017 down to maybe 10% this year. The vast majority will not itemize.
Megan Brinsfield: Itemizing was already something that few people did, and now even fewer will do it.
Brokamp: There's elimination of many assorted deductions. Too many to list, but some of the more common ones were unreimbursed employee expenses, tax prep expenses. So, Megan, and all your CPA colleagues. Moving expenses. A lot of those things have just gone away.
Also the elimination of exemptions, but the expanded child tax credit, which is good. And perhaps one of the more controversial is the limitation on the SALT deduction [the state and local taxes deduction]. Now the total amount that you can deduct is $10,000 per year. And this is probably one of the bigger reasons why some people will be paying higher taxes this year than last year.
Brinsfield: Exactly. You hear a lot of cries from higher tax states. People living in places like California or New York where they're paying 10% annually in taxes and they have to, in general, earn a lot to live in those places. So they would have had a much higher deduction under the old plan.
I just did my taxes last night. I am an extender and I was looking at how much benefit that provided me, and I'm by far not earning anywhere near what a lot of people in California and New York are, and so I can definitely feel that pain. The good news is that on the flip side, a lot of people who are itemizing are families that have kids and will benefit from a much higher child tax credit than has been seen in the past. The expansion of that was very large. So now if you're a married couple, you can have up to $400,000 of income before your child tax credit starts getting phased out and it used to be something like $110,000. So that's a huge band of people that that credit is now open to.
Brokamp: Just to be clear, when the law was passed at the end of last year, a lot of states tried to get around this limitation on the SALT deduction, but in the end none of those are going to work, right?
Brinsfield: Right. The IRS sort of squashed those workarounds with proposed regulations that they issued over the summer. And the workaround was the state would create this charitable entity and people could make charitable contributions, which are still deductible to an almost unlimited extent, and the state would then give you an offsetting credit for your charitable contributions to that fund.
And the IRS said, "No, that doesn't pass the smell test." You're getting services back equal to the amount that you're paying, which I'm sure someone, somewhere, could argue against. But it sort of put an end to those potential workarounds that were alive and brewing for about six months.
Brokamp: A lot about the new law had to do with corporate tax rates, as well. We're not going to get into those. We're going to talk mostly about individual tax rates. That said, for those who are business owners, one big change was the 20% pass-through deduction. What exactly was that and is that? I know there was some confusion about it and there was relatively recently some clarification about who can take that and who can't.
Brinsfield: The biggest thing is that it defines pass-through entities a bit more broadly than it has in the past among tax professionals. It used to be things like LLCs, S corporations, and partnerships were pass-through entities. Now under this law you're actually adding in sole proprietorships, which are people who basically never bothered to set up a business entity and allows them to deduct 20% of their net income, assuming they don't make too much.
This is a place where what is earned inside the business actually coordinates with everything else you earn on your return and if you're mad at your spouse for messing up your taxes, they can do it particularly well in this area, as well, because you're looking not only at business income, but if your total income exceeds a threshold [I think it's $157,000 if you are single and $315,000 if you're married], if you have a high-earning spouse that can kick you out of being qualified to take this deduction on your business.
Brokamp: I seem to recall reading that after this was passed, there were some people who were thinking "I'm an employee now, but I love the idea of this 20% deduction on everything I earn. Maybe I'll just become an independent contractor and take this." But that also has been somewhat squashed, right?
Brinsfield: I don't think it's been as formerly squashed as it has been just impractical. Being an employee or a contractor comes with different assumptions around the work that you're doing and who has control over your time and who's responsible for a lot of expenses.
So if you say, "I want to be a contractor," suddenly you're signing up to take care of your own healthcare, computer, and work expenses that might have been covered by your employer in the past, and that's not necessarily going to equal out with this deduction going forward. The other thing is that the law says if you have a business that is solely relying on your skills, you can't really separate yourself from the business entity; then you're even further limited in taking this 20% deduction.
Megan Brinsfield is an employee of Motley Fool Wealth Management, a separate, sister company of The Motley Fool, LLC. The information provided is intended to be educational only, and should not be construed as individualized advice. For individualized advice, please consult a financial professional. The Motley Fool has a disclosure policy.