Individual Income Tax Provisions of the Tax Cuts & Jobs Act – Updated w/ Senate Plan

The Senate has now released its version of the Tax Cuts & Jobs Act.  I thought it would be helpful to re-post the House plan points from my last blog post and update with how the Senate plan would treat each item.  Again, all of this is subject to change before a final bill is put together and voted upon.  Each chamber needs to pass its version of the bill (after votes on various amendments).  Then the two bills will be reconciled in Committee to produce a final bill.  Then both chambers need to pass that bill.  Then the President needs to sign it.  Long path ahead with many changes likely.

  • Income tax rates fall for everyone. The current 7 tax brackets would be compressed into 5: 0%, 12%, 25%, 35% and 39.6% (the 0% rate applies due to deductions and exemptions which subtract from income causing the first $x of income to be subject to no tax).. For singles, the 12% rate would run to $45,000, the 25% rate would top out at $200,000, the 35% one would end at $500,000, and the 39.6% rate would kick in for taxable incomes that exceed $500,000. For marrieds, 12% rate up to $90,000, 25% would max out at $260,000, 35% would end at $1 million, and the 39.6% rate would apply above $1 million. The 12% on the first $45k or 90k of income wouldn’t apply for those in the top tax bracket. Note that this schema reduces the marriage penalty that exists in the current tax brackets since the married brackets (with the exception of the 25% bracket) are double the single brackets.

Senate Plan: 8 brackets, like today, but with different rates and caps.  Those rates are 0%, 10%, 12%, 22.5%, 25%, 32.5%, 35%, and 38.6%, with the top bracket at $500k single, $1M married, like the House plan.  Would also change the “kiddie tax” such that a child’s investment income is taxed with trust and estates rates (higher), vs. being taxed at the parent rate after a threshold.

  • No change in tax rates for dividends and long-term capital gains. 0% applies if income puts you in the old 0%, 10%, or 15% tax bracket, 15% applies if in the prior 25%, 33%, or 35% bracket, and 20% applies if in the old 39.6% bracket.

Senate Plan is the same and specifically calls out that only the FIFO (first in first out) method of tax lot reporting will be allowed for the determination of gain (or average cost in the case of funds).

  • AMT is completely repealed.

Senate Plan is the same.

  • The standard deduction is increased for everyone, but the personal exemption no longer applies. The standard deduction would be $24k for married filers (vs $13k now) and $12k for singles (vs. $6500 now). The $4150 per person personal exemption (which was phased out for upper incomers and treated differently for those in AMT) is eliminated.

Senate Plan is the same, thought the house plan eliminated the extra standard deduction for those age 65 and over and those who are blind while the Senate retains those additional standard deduction amounts.

  • The child tax credit is increased. It would be $1600 per dependent age 16 and under (vs $1000 today). The income phaseouts are increased as well ($75k single / $115k married now to $115k single / $230k married).

Senate Plan would increase the credit to $1650 per dependent, raise the age to age 17 and under, and raise the income phaseouts to $500k single, $1M married.

  • A new, temporary $300 tax credit for each adult taxpayer and each dependent over age 16. This applies for 5 years only and essentially offsets part of the loss of the personal exemption. It also phases out at higher incomes.

Senate Plan does not include this new temporary credit.

  • Several credits go away. These include:
    • Adoption Credit
    • Credit for purchase of Plug-In Vehicles
    • Hope Scholarship Credit & Lifetime Learning Credit, though the larger American Opportunity Credit remains.

Senate Plan retains these credits

  • Several itemized deductions go away or are reduced. Keep in mind though that with the higher standard deductions, fewer people will need to itemize so loss of some of the below isn’t as bad as it seems.  These include:
    • State and local tax deduction eliminated.  Senate Plan is the same.
    • Property tax deduction limited to $10k per year and only applies to real estate (no more auto registration deduction).  Senate Plan completely eliminates the property tax deduction.
    • Mortgage interest deduction would only be allowed on up to $500k of new mortgage debt (vs. $1M today), only for primary residences (vs. first and second homes today), and there would be no more $100k of HELOC debt interest deduction allowed. Existing mortgages (closing prior to 11/2/2017 or with a binding contract prior to that date) would be grandfathered in the old rules.  Senate Plan retains the $1M cap, but still eliminates the $100k of HELOC debt interest deduction.
    • Casualty loss deduction eliminated (unless specifically authorized by special disaster relief).  Senate Plan is the same.
    • Medical expenses > 10% of AGI deduction eliminated.  Senate plan retains this deduction.
    • Tax prep fees, and unreimbursed employee expenses (including mileage) would be eliminated.  Senate plan also eliminates these deductions, but goes a step further by eliminating all Misc. Itemized Deductions that are subject to the 2% of AGI floor (see IRS Publication 529 for a list of these deductions)
  • Other deductions / exclusions go away or are reduced.  These include:
    • Moving expenses deduction eliminated.  Senate Plan is the same.
    • Alimony deduction eliminated and alimony would no longer be taxable to the receiver.  Senate plan does not modify alimony rules.
    • The student loan interest deduction is eliminated.  Senate plan retains this deduction.
    • The tuition and fees deduction is eliminated.  Senate plan retains this deduction.
    • Sec 121 exclusion of gain on the sale of a principal residence is significantly changed. Instead of the exclusion applying regardless of income as long as the seller owned and lived in the residence for 2 of the last 5 years, the exemption would now be phased out for upper incomers (starts at $250k individual and $500k married) and the own/live requirement would be 5 of the last 8 years.  Senate Plan also includes the 5 of the last 8 condition, but excludes the income caps.
  • Retirement accounts are unchanged (401ks, Traditional IRAs, Roth IRAs, SEPS, SIMPLES, etc. Note that there are strong rumors that the Senate plan will change this, removing or reducing the ability to save pre-tax for retirement.

Senate Plan makes some changes to 457, 403b, and 401k plans so that they all use the limits of today’s 401k plans (no additional catch-up for 403b and governmental 457 plans going forward).  It also clarifies that the aggregate contribution rules apply across all retirement plans, not just retirement plans of the same type.  Finally, it eliminates “catch-up” contributions for individuals whose wages exceeded $500k in the prior year.

  • 529 College Savings Plans would be enhanced. Specifically:
    • $10,000/year of tax-free distributions would be allowed from 529 college savings plans for (private) elementary and high school expenses
    • 529s could be created for unborn children

Senate Plan does not include these changes.

  • The estate tax would be reduced and then eliminated. The exemption would be doubled for 2018 and eliminated completely in 2024. The gift tax system would be kept in place to prevent gaming the income tax system by shifting assets to those in lower tax brackets.

Senate Plan doubles current exemptions, but keeps the estate tax in place.

  • ACA (“Obamacare”) provisions remain unchanged. The Individual Mandate (requiring health insurance or paying a penalty) remains, as do the other ACA-imposed Medicare surtaxes on wages and investment income.

Senate Plan also leaves the ACA unchanged.  

  • Some employee benefits changes. These include:
    • No more dependent care FSAs
    • No more adoption benefits
    • No more tuition reimbursement plans and no more reduced / free tuition for employees of educational institutions.
    • No more moving expense reimbursements.
    • No more pre-tax transportation plans (parking / commuting).
    • No more free gym memberships or similar amenities without including their value in taxable income.
    • 401k hardship withdrawals would still be subject to tax and penalties, but could now include employer contributions and employees would no longer be prevented from making new contributions to the plan for 6 months.
    • 401k plan loan repayments get a little easier in the case of a termination. Rather than needing to repay the loan within 90 days of termination or treating the loan as a distribution, borrowers would have the ability to repay the loan to a new retirement plan or IRA by the due date of that year’s tax return (including extensions).

Senate Plan does not contain this language except for the moving expense reimbursements.  Those would not be allowed in the Senate plan either.  There would also no longer be deductions to the employer for (1) an activity generally considered to be entertainment, amusement or recreation, (2) membership dues with respect to any club organized for business, pleasure, recreation or other social purposes, or (3) a facility or portion thereof used in connection with any of the above items.

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Individual Income Tax Provisions of the Tax Cuts & Jobs Act

The House of Representatives recently released the first draft of the long-anticipated tax overhaul bill, now called the “Tax Cuts & Jobs Act”. The bill itself is 429 pages of text, addressing both Corporate and Individual tax laws. I’m 100% confident that the final bill, after reconciliation with the Senate’s still-unreleased-version, will look remarkably different than this first version. As such, we don’t recommend any action at this time. But, I still thought it would be helpful for you to understand what’s being proposed. Some quick highlights on the Individual side of the bill are below:

  • Income tax rates fall for everyone. The current 7 tax brackets would be compressed into 5: 0%, 12%, 25%, 35% and 39.6% (the 0% rate applies due to deductions and exemptions which subtract from income causing the first $x of income to be subject to no tax).. For singles, the 12% rate would run to $45,000, the 25% rate would top out at $200,000, the 35% one would end at $500,000, and the 39.6% rate would kick in for taxable incomes that exceed $500,000. For marrieds, 12% rate up to $90,000, 25% would max out at $260,000, 35% would end at $1 million, and the 39.6% rate would apply above $1 million. The 12% on the first $45k or 90k of income wouldn’t apply for those in the top tax bracket. Note that this schema reduces the marriage penalty that exists in the current tax brackets since the married brackets (with the exception of the 25% bracket) are double the single brackets.
  • No change in tax rates for dividends and long-term capital gains. 0% applies if income puts you in the old 0%, 10%, or 15% tax bracket, 15% applies if in the prior 25%, 33%, or 35% bracket, and 20% applies if in the old 39.6% bracket.
  • AMT is completely repealed.
  • The standard deduction is increased for everyone, but the personal exemption no longer applies. The standard deduction would be $24k for married filers (vs $13k now) and $12k for singles (vs. $6500 now). The $4150 per person personal exemption (which was phased out for upper incomers and treated differently for those in AMT) is eliminated.
  • The child tax credit is increased. It would be $1600 per dependent age 16 and under (vs $1000 today). The income phaseouts are increased as well ($75k single / $115k married now to $115k single / $230k married).
  • A new, temporary $300 tax credit for each adult taxpayer and each dependent over age 16. This applies for 5 years only and essentially offsets part of the loss of the personal exemption. It also phases out at higher incomes.
  • Several credits go away. These include:
    • Adoption Credit
    • Credit for purchase of Plug-In Vehicles
    • Hope Scholarship Credit & Lifetime Learning Credit, though the larger American Opportunity Credit remains.
  • Several itemized deductions go away or are reduced. Keep in mind though that with the higher standard deductions, fewer people will need to itemize so loss of some of the below isn’t as bad as it seems.  These include:
    • State and local tax deduction eliminated
    • Property tax deduction limited to $10k per year and only applies to real estate (no more auto registration deduction).
    • Mortgage interest deduction would only be allowed on up to $500k of new mortgage debt (vs. $1M today), only for primary residences (vs. first and second homes today), and there would be no more $100k of HELOC debt interest deduction allowed. Existing mortgages (closing prior to 11/2/2017 or with a binding contract prior to that date) would be grandfathered in the old rules.
    • Casualty loss deduction eliminated (unless specifically authorized by special disaster relief).
    • Medical expenses > 10% of AGI deduction eliminated.
    • Tax prep fees, and unreimbursed employee expenses (including mileage) would be eliminated.
  • Other deductions / exclusions go away or are reduced.  These include:
    • Moving expenses deduction eliminated.
    • Alimony deduction eliminated and alimony would no longer be taxable to the receiver.
    • The student loan interest deduction is eliminated.
    • The tuition and fees deduction is eliminated.
    • Sec 121 exclusion of gain on the sale of a principal residence is significantly changed. Instead of the exclusion applying regardless of income as long as the seller owned and lived in the residence for 2 of the last 5 years, the exemption would now be phased out for upper incomers (starts at $250k individual and $500k married) and the own/live requirement would be 5 of the last 8 years.
  • Retirement accounts are unchanged (401ks, Traditional IRAs, Roth IRAs, SEPS, SIMPLES, etc. Note that there are strong rumors that the Senate plan will change this, removing or reducing the ability to save pre-tax for retirement.
  • 529 College Savings Plans would be enhanced. Specifically:
    • $10,000/year of tax-free distributions would be allowed from 529 college savings plans for (private) elementary and high school expenses
    • 529s could be created for unborn children
  • The estate tax would be reduced and then eliminated. The exemption would be doubled for 2018 and eliminated completely in 2024. The gift tax system would be kept in place to prevent gaming the income tax system by shifting assets to those in lower tax brackets.
  • ACA (“Obamacare”) provisions remain unchanged. The Individual Mandate (requiring health insurance or paying a penalty) remains, as do the other ACA-imposed Medicare surtaxes on wages and investment income.
  • Some employee benefits changes. These include:
    • No more dependent care FSAs
    • No more adoption benefits
    • No more tuition reimbursement plans and no more reduced / free tuition for employees of educational institutions.
    • No more moving expense reimbursements
    • No more pre-tax transportation plans (parking / commuting).
    • No more free gym memberships or similar amenities without including their value in taxable income.
    • 401k hardship withdrawals would still be subject to tax and penalties, but could now include employer contributions and employees would no longer be prevented from making new contributions to the plan for 6 months.
    • 401k plan loan repayments get a little easier in the case of a termination. Rather than needing to repay the loan within 90 days of termination or treating the loan as a distribution, borrowers would have the ability to repay the loan to a new retirement plan or IRA by the due date of that year’s tax return (including extensions).

There are many other (and mostly more complicated) changes on the corporate and small business side of things. I suspect even more of those proposed changes will be substantially modified before the final bill. In an effort to keep the length of this post manageable, I’ll refrain from getting into the Corporate changes at this time.

The effective date for most of the changes, on both the Individual and Corporate side, would be the start of 2018, though that could also change. Current prediction markets (via PredictIt) imply an 86% chance of the House voting on the Tax Cuts & Jobs Act in 2017, an 81% chance of passing it (including any changes between now and the final bill) in 2017, a 47% chance of a Senate vote on their version of the bill in 2017 and a 27% chance of the Senate passing their version in 2017. There is also a market on a Corporate tax cut by 3/31/2018, giving a 65% chance of success. If those are correct, it would mean progress by end of year, but likely not passage until sometime in early 2018 (if at all).

American Taxpayer Relief Act (ATRA) a.k.a. Fiscal Cliff Deal

I’ve parsed through the legislation (which can be found here if you want to check it out for yourself), as well as a ton of analysis, and to the best of my ability, here’s a quick summary of the relevant portions of the new law that averted the tax portion of the fiscal cliff. Note that while $400k/450k are getting all the press for paying higher taxes, there are a number of provisions which impact $200k(single)/$250k(married), and one really big one that impacts everyone (Payroll Tax Holiday Ended):

· Income Tax Rates: All existing rates remain the same with brackets increased for inflation (10%, 15%, 25%, 28%, 33%, 35%) and a new 39.6% bracket begins at taxable income over $400k for singles and $450k for joint filers.

· Long-Term Capital Gains: These were set to move from 0% for the bottom two tax brackets and 15% for everyone else to 20% for everyone. The legislation keeps the 0% and 15% rates for everyone except those in the new 39.6% tax bracket. They’ll pay 20% (not including the new Obamacare Medicare Surtax, see below).

· Dividend Rates: These were set to move from 0% for the bottom two tax brackets and 15% for everyone else to ordinary income rates for everyone. The legislation keeps this rate tied to the long-term capital gains rate with the same rules as above.

· Estate Tax Rates & Exemption: Retained the $5M per person exemption (was set to reset to $1M) and kept it portable (each spouse gets $5M instead of the couple getting $10M which forces complicated bypass trusts to be set up to try to use the $5M from the first to die spouse). Set the top tax rate at 40% (up from 2012’s 35%, but down from the 55% to which 2013 was due to revert).

· AMT Exemption: Patched the AMT exemption amount to the 2011 amount, increased for inflation. This was a big one since it was 2012 they were fixing, not 2013. Even better, they permanently fixed this so that each year’s exemption will be indexed to inflation going forward. This means no end of year scramble to get an AMT patched passed each year.

· Phaseout of Itemized Deductions: this was due to happen in 2013 without any new law, but ATRA tweaked the thresholds. If you are Single with AGI over $250k or married with AGI over $300k, your itemized deductions will be reduced by 3% of the amount that your AGI exceeds the threshold, up to a maximum reduction of 80% of your itemized deductions. To simplify, if you’re over the threshold by $10k, you lose $300 of itemized deductions. If you’re over by $100k, you lose $3k.

· Phaseout of Exemptions: this was also due to happen in 2013, but ATRA unified the phaseout level with the Itemized deduction phaseout. If you are Single with AGI over $250k or married with AGI over $300k, your exemptions ($3800 per family member) are reduced by 2% for every $2500 that you’re over the threshold. To simplify, if you’re over by $10k, you lose 8% of your exemptions. If you’re over by $100k, you lose 80% of your exemptions. This can be a pretty big bite.

· Payroll Tax Holiday Ended: this was due to happen in 2011, but was extended for two years and now is finally gone. It impacts everyone with income from work (employment or self-employment) by restoring the employee portion of Social Security (FICA) tax to 6.2% from 4.2%. This means everyone will pay 2% more tax in getting this level back to its pre-2011 setting (which still grossly underfunds Social Security over the long-term).

· Marriage Penalty: The standard deduction for married filers and the 15% tax brackets were due to revert to 1.67x the single amounts. ATRA kept them at 2x the single amount and made that change permanent. There is still a very large marriage penalty in the code anyway, as described here.

· Bonus Depreciation & Higher 1st Year Expensing: For business owners, 50% bonus depreciation on new purchases is extended into 2013 as is the higher limit for immediate expensing of certain purchases (Section 179).

· Misc. Permanent Extensions: Child Tax Credit ($1k per child subject to limits), Exclusion for Employer Provided Tuition Assistance ($5250 tax free reimbursement).

· Misc. Temporary Extensions: American Opportunity Tax Credit (college), teacher’s deduction ($250), exclusion from discharge of debt on primary residence (no income on short-sale or foreclosure), deduction for Mortgage Insurance Premiums, Deduction for State and Local Sales Tax paid (big in no income tax states), Tuition Deduction.

While not included in the ATRA legislation, it’s important to remember that two new fairly large changes also being in 2013 as Obamacare is rolled out. They are:

1) 0.9% Medicare Surtax on earned income (income from work) that exceeds $200k (single) or $250k (married). It’s important to note here that this will cause underwithholding from your employer if you have multiple jobs or are marred and both spouses have income since payroll systems will not realize that your earned income will exceed $200k/250k until you exceed that amount from a single employer.

2) 3.8% Medicare Surtax on investment income (interest, dividends, capital gains, rents collected, passive business income) if your Adjusted Gross Income exceeds $200k (single) or $250k (married). While there is no withholding on most investment income and you’re used to paying tax when filing or making estimated tax payments on that income through the year, the 3.8% additional tax effectively raises the tax rates on interest, dividends, gains, etc., even if you don’t meet the now well-publicized $400k (single) / $450k (married) income from the fiscal cliff deal.

I have no doubt that more tax changes will come in 2013 and/or 2014 since ATRA only reduces the > $1 trillion deficit by ~$60 billion per year, so it’s hard to count on anything above as permanent even where legislation made it permanent. The next major debate, likely to be more focused on spending than taxes will be in February as the Debt Ceiling will need to be raised again at that time. It’s quite possible that taxes, especially beyond 2013, become part of that negotiation as well.

The Marriage Penalty

No, I don’t mean the price of dealing with your spouse on an every-day basis as many sitcoms illustrate (frankly, I don’t consider that a penalty at all in case you’re reading this, honey!). I’m talking about the “features” built into the tax code so that a married working couple pays more tax than the same two working individuals would if they were not married. Few people understand this, but it can have a really big impact on your taxes when you get married and starting in 2013, the impact will be even bigger.

Let’s start with the most basic form of the marriage penalty, the tax brackets. Table 1 shows the starting income level for each 2012 income tax bracket for both the single and joint filer. As I described in Am I Working Too Much, a taxpayer pays tax at the rate indicated in the table for each bracket. For example, a single taxpayer would pay 10% tax on her first $8,700 of taxable income + 15% tax on her next $26,650 of taxable income up to $35,350 + 25% on her next $50,300 of income and so on. A married couple would pay tax in the same manner using the married tax brackets. Notice that while for the lower tax rates, the married bracket is two times the single bracket, the higher your income, the faster the married tax brackets increase vs. the single tax rates. This closes the gap between the married brackets and single brackets slowly until they are identical once reaching the top tax bracket. Let’s use an example to see the impact on two individuals, each with $150k of taxable income who get married. As single filers, they each pay 10% of $8700 + 15% of $26,650 + 25% of $35,350 + 28% of the remaining $64,350 for a total tax bill of $35,461 each or $70,922 in total. As married filers, using the married part of the table and a similar calculation, they’d pay $75,907 in tax. This additional ~$5k of tax is the most basic form of the marriage penalty. Note that electing to file Married Filing Separately does not reduce the marriage penalty since the MFS brackets are not the same as the Single brackets. Instead they are ½ of the Married Filing Jointly brackets. Additionally, it is not legal to file as a single taxpayer if you are legally married so you can’t just choose to file Single. To make things worse, starting in 2013 after the “Bush tax cuts” are eliminated, the multiple for the 25% tax bracket will be 1.67, instead of 2 as it is today. That will compress the 25% tax bracket for married filers down to $58,900 and add another few hundred dollars of tax.

There are other forms of marriage penalty in the tax code as well, some in existence now and others coming back in 2013 after the Bush tax cuts expire:

· For those claiming the standard deduction, the married standard deduction is currently $11,900, exactly twice the single deduction of $5,950. Starting in 2013 though, the old standard deduction marriage penalty kicks in here too with the standard deduction for married filers reverting back to ~1.67 times the single deduction (would have been $8700 for 2012).

· The qualifying income level for the Earned Income Tax Credit for married filers is less than 2x the Single levels.

· The new healthcare reform taxes starting in 2013 on investment income and earned income only impact those single filers with income up to $200k, but hit married filers starting at $250k per year in income).

· For those paying the Alternative Minimum Tax (AMT), the personal exemption for a married couple is less than 2x the Single level.

· The reduction in itemized deductions and personal exemptions which is due to return in 2013 will start at an income level for married couples that is less than twice the single income level.

· The threshold for determining whether a married couple’s social security benefits are taxable is substantially less than 2x that of a single filer.

· Multiple other deductions, credits, and exclusions in the tax code phase-out for married couples at less than 2x the single level including deductible IRA contributions, Roth IRA contributions, the Child Tax Credit, the deduction for capital losses taken in any one year, and the deduction for current year loss on a rental property.

More to come on the marriage penalty in future posts regarding 2013 tax changes.