The passage of the Tax Cuts and Jobs Act (TCJA) on December 22, 2017, brought significant and abrupt changes to the tax code. The broad impact of these changes has yet to be fully realized, but it’s likely that just about everyone will be affected come tax season. As you work to help your clients pursue their financial aspirations, keeping a focus on managing your clients’ tax liability is essential. An understanding of the following four changes under the TCJA, as well as the opportunities they present, can help keep your clients’ planning strategies on track.
1) New SALT Deduction Limitations
One of the more controversial aspects of the TCJA is the new $10,000 cap on the state and local taxes (SALT) deduction. Prior to the passage of the TCJA, when assessing a home purchase in areas with high property taxes, prospective homeowners could justify the purchase in part because many of the major home ownership expenses (e.g., mortgage interest, property taxes) were fully tax deductible. Now, taxpayers may only deduct these expenses up to $10,000.
Many have argued that this new provision disproportionately affects certain states, such as New York and California, where a person’s real estate property taxes alone could easily exceed $10,000—not to mention additional state income taxes. Now, given the limitations of the SALT deduction, a much higher percentage of individuals will use the standard deduction, regardless of their home ownership expenses.
Many states have contested the constitutionality of the new deduction, and some have sought to pass laws to enable their residents to get the benefit of a tax deduction by essentially recategorizing certain state tax obligations as charitable contributions. None of these maneuvers have affected the deduction yet, however, and the IRS recently issued regulations to try to prevent states from allowing taxpayers to claim a charitable deduction in this manner.
How can you help your clients? Ensure that your clients are aware of this change in the tax code and how it will affect them individually, especially if they are considering purchasing a home in an area with high property taxes. Encourage them to seek the guidance of a tax professional to help with any specific questions or concerns they may have.
2) Higher Standard Deduction
One unfortunate consequence of the higher standard deduction ($12,000 for single filers and $24,000 for couples) put in place by the TCJA is that it disincentivizes charitable giving. While the charitable deduction has not been eliminated (in fact, the deduction limit for cash contributions has been increased to 60 percent of the donor’s adjusted gross income), in order to receive the benefit of a charitable deduction, an individual or couple must elect to itemize deductions.
The problem here is that the increase in the standard deduction, coupled with the fact that many other deductions are now limited, means that many taxpayers who previously itemized their deductions will now find it more beneficial to take the standard deduction. So, if a donor’s charitable contributions (combined with all of their other available deductions) do not exceed the standard deduction, then he or she wouldn’t receive a direct tax benefit from a cash gift to charity.
How can you help your clients? While this is disappointing to some, there are planning options available to help clients maximize the tax benefit of a charitable cash gift.
One strategy is to establish a donor-advised fund (DAF). For example, if a couple gives $5,000 to their local church every year, the annual donation may not be enough to justify itemizing deductions rather than using the new standard deduction. In this case, a DAF could be a great tool to fulfill their charitable intent while optimizing the tax benefit. The strategy could work like this:
- The donors establish a DAF in their names.
- They contribute five years’ worth of donations ($25,000) up front.
- They direct grants of $5,000 from the DAF to their church each year for five years.
In this scenario, the donors are guaranteeing a tax benefit up front by taking advantage of a large charitable deduction bunched into one year. Consider discussing this option with your clients to see if it might be feasible and beneficial, given their individual circumstances.
3) Increased Federal Estate Tax Exemption
The federal estate tax exemption has doubled under the TCJA to $11,180,000 per individual ($22,360,000 per couple). This means that far fewer families will need a federal estate tax planning component to their estate plan, but that doesn’t mean tax obligations arising from death should be disregarded altogether.
For example, over the past few decades, many couples have turned to the AB trust to shelter their assets from the estate tax. With an AB trust (also known as a bypass trust) design, when the first spouse dies, the bypass trust is funded with an amount equal to the applicable exclusion amount in order to minimize federal and state estate taxes. Any remaining marital assets would transfer to the surviving spouse outright or be held in trust for his or her benefit. Because of the increase in the estate tax exemption, this type of trust planning could result in unnecessary restrictions on the surviving spouse. In addition, the beneficiaries of the estate could eventually incur more capital gains taxes due to a loss in a step-up in basis at the death of the surviving spouse.
How can you help your clients? Revisiting estate plans is essential for managing your clients’ tax liability, especially as there is a possibility that the threshold may come back down in the future. In this new tax environment, weighing potential estate tax versus capital gains tax liabilities is essential. If, upon revisiting your clients’ estate plan, it’s clear that the plan is no longer effective, you might discuss possible adjustments with your clients’ estate planning attorney present.
4) K–12 Tuition Included in 529 Plan Qualified Expenses
One of the more surprising changes under the TCJA is the expansion of the qualified expenses rules for 529 educational savings accounts: tuition for K–12 education is now considered a qualified education expense, meaning it’s not subject to taxation upon distribution. Previously, Coverdell accounts were the only tax-favored type of account available for funding K–12 education, so this change is attractive to many clients who are funding their minor children’s educations.
Not all states are excited about the change, however. As many states offer tax deductions for contributions to state-sponsored 529 plans, this change in the law potentially opens the opportunity for taxpayers to use a child’s 529 account simply as a way to receive a tax deduction on the tuition bill. Various states have issued statements indicating that, for state income tax purposes, distributions from 529 plans for K–12 tuition could be deemed taxable.
How can you help your clients? Remind them that traditional qualified expenses for higher education include room and board and school supplies; however, only tuition is a qualified expense for K–12 education. Therefore, attempting to pay for any elementary or secondary school expenses outside of tuition with money from a 529 plan could expose that money to tax and penalty. Further, as this law is so new, it’s important to ensure that clients know how their state is handling this new change and perhaps encourage them to take a conservative approach to distributions from 529 plans until more information becomes available.
Making the Most of New Opportunities
As we near year-end, reminding your clients of these changes and discussing potential revisions to their financial and estate plans can help them take advantage of opportunities afforded under the TCJA. By staying up to date on the changes that are likely to affect your clients the most, you can ensure that they feel confident in their plans going into the upcoming tax season.
Have you revisited your clients’ financial and estate plans to account for changes under the TCJA? Do you bring in tax and legal professionals when managing your clients’ tax liability? Please share your thoughts with us below.
Commonwealth Financial Network® does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.