Most of the provisions of the Tax Cuts and Jobs Act (TCJA) went into effect in 2018. But the massiveness of the changes mean that they’re still having a major impact on tax planning.
First, you need to consider that the TCJA reduced the rates for all individual income tax brackets except 35% and 10%, which remain the same, and adjusted the income ranges each bracket covers. These rates apply to “ordinary income,” which generally includes salary, income from self-employment or business activities, interest, and distributions from tax-deferred retirement accounts.
But there are other taxes you need to keep in mind as well, such as the alternative minimum tax (AMT), for which the TCJA provides some relief, and employment taxes, which the TCJA generally doesn’t affect.
You also need to consider the various tax deductions and credits that could save you taxes. The TCJA expands some tax breaks, but it also reduces or eliminates breaks that had been valuable to many taxpayers. And you need to keep in mind that income-based phase-outs and other limits can reduce or eliminate the benefits of these breaks, effectively increasing your marginal tax rate.
The standard deduction vs. itemized deductions
Taxpayers can choose to itemize certain deductions on Schedule A or take the standard deduction based on their filing status instead. Itemizing deductions when the total will be larger than the standard deduction saves tax, but it makes filing more complicated.
The TCJA nearly doubled the standard deduction for each filing status. Those amounts are to be annually indexed for inflation through 2025, after which they’re scheduled to drop back to the amounts under pre-TCJA law. The combination of a higher standard deduction and the reduction or elimination of many itemized deductions means more taxpayers will find that the standard deduction exceeds their itemized deduction. This could have a significant impact on timing strategies.
Timing income and expenses
Smart timing of income and expenses can reduce your tax liability, and poor timing can unnecessarily increase it.
When you don’t expect to be subject to the AMT in the current year or the next year, deferring income to the next year and accelerating deductible expenses into the current year typically is a good idea. Why? Because it will defer tax, which is usually beneficial.
But when you expect to be in a higher tax bracket next year — or you expect tax rates to go up — the opposite approach may be beneficial: Accelerating income will allow more income to be taxed at your current year’s lower rate. And deferring expenses will make the deductions more valuable, because deductions save more tax when you’re subject to a higher tax rate.
Whatever the reason behind your desire to time income and expenses, here are some income items whose timing you may be able to control:
• Consulting or other self-employment income,
• U.S. Treasury bill income, and
• Retirement plan distributions, to the extent they won’t be subject to early-withdrawal penalties and aren’t required.
And here are some potentially controllable expenses:
• State and local income taxes,
• Property taxes,
• Mortgage interest,
• Margin interest, and
• Charitable contributions.
Impact of the TCJA on timing strategies
The TCJA makes timing income and deductions more challenging, because some strategies that taxpayers have implemented in the past may no longer make sense. Here’s a look at some significant changes affecting deductions:
Reduced deduction for state and local tax. Property tax used to be a popular expense to time. But with the new limit on the state and local tax deduction, property tax timing will likely provide little, if any, benefit for many taxpayers.
Through 2025, the TCJA limits your entire deduction for state and local taxes — including property tax and either income tax or sales tax — to $10,000 ($5,000 if you’re married filing separately). This is having a significant impact on higher-income taxpayers with large state and local income tax and/or property tax bills.
Individuals generally can take an itemized deduction for either state and local income tax or state and local sales tax. For most taxpayers, deducting state and local income taxes will provide more tax savings. But deducting sales tax can be more valuable to taxpayers residing in states with no or low income tax or who purchase a major item, such as a car or boat.
Except for major purchases, you don’t have to keep receipts and track all the sales tax you actually paid during the year. Your deduction can be determined using an IRS sales tax calculator that will base the deduction on your income and the sales tax rates in your locale plus the tax you actually pay on major purchases.
Suspension of miscellaneous itemized deductions subject to the 2% floor. This deduction for expenses such as certain professional fees, investment expenses and unreimbursed employee business expenses is suspended through 2025. If you’re an employee and work from home, this includes the home office deduction. (If you’re self-employed, you may still be able to deduct home office expenses.)
More-restricted personal casualty and theft loss deduction. Through 2025, this itemized deduction is suspended except if the loss was due to an event officially declared a disaster by the President.
Health care breaks
If medical expenses not paid via tax-advantaged accounts or reimbursable by insurance exceed a certain percentage of your adjusted gross income (AGI), you can claim an itemized deduction for the amount exceeding that “floor.”
The TCJA had reduced the floor from 10% to 7.5% for 2017 and 2018, but it will be 10% when you file your 2019 tax return unless Congress extends the 7.5% floor. (Check back here for updates.)
Eligible expenses may include:
• Health insurance premiums,
• Long-term care insurance premiums (limits apply),
• Medical and dental services,
• Prescription drugs, and
• Mileage (20 cents per mile driven in 2019).
When a deduction is subject to a floor, “bunching” expenses into one year that normally would be spread over two years can save tax. So consider bunching elective medical procedures (and any other services and purchases whose timing you can control without negatively affecting your or your family’s health) into alternating years if it would help you exceed the applicable floor and you’d have enough total itemized deductions to benefit from itemizing.
Also keep in mind that if one spouse has high medical expenses and a relatively lower AGI, filing separately may allow that spouse to exceed the AGI floor and deduct some medical expenses that wouldn’t be deductible if the couple filed jointly. Warning: Because the AMT exemption for separate returns is considerably lower than the exemption for joint returns, filing separately to exceed the floor for regular tax purposes could trigger the AMT.
Expenses that are reimbursable by insurance or paid through a tax-advantaged account such as the following aren’t deductible:
HSA. If you’re covered by a qualified high-deductible health plan, you can contribute pretax income to an employer-sponsored Health Savings Account — or make deductible contributions to an HSA you set up yourself — up to $3,500 for self-only coverage for 2019 (up from $3,450 for 2018), and $7,000 for family coverage for 2019 (up from $6,900 for 2018). Moreover, you may contribute an additional $1,000 if you’re age 55 or older.
HSAs can bear interest or be invested, growing tax-deferred similar to an IRA. Withdrawals for qualified medical expenses are tax-free, and you can carry over a balance from year to year.
FSA. You can redirect pretax income to an employer-sponsored Flexible Spending Account up to an employer-determined limit (not to exceed $2,700 for plan year beginning in 2019, up from $2,650 for 2018). The plan pays or reimburses you for qualified medical expenses. With limited exceptions, you have to make your election before the start of the plan year. What you don’t use by the end of the plan year, you generally lose — though your plan might allow you to roll over up to $500 to the next year. Or it might give you a 2½-month grace period to incur expenses to use up the previous year’s contribution. If you have an HSA, your FSA is limited to funding certain “permitted” expenses.
Smaller AMT threat
The top AMT rate is 28%, compared to the top regular ordinary-income tax rate of 37%. But the AMT rate typically applies to a higher taxable income base.
The TCJA has increased the AMT exemptions through 2025. (See the Chart “2019 individual income tax rate schedules.”)
There are now fewer difference between what’s deductible for AMT purposes and regular tax purposes, (see the Chart “Regular tax vs. AMT: What’s deductible?”) which also will reduce AMT risk. However, AMT will remain a threat for some higher-income taxpayers.
So before taking action to time income or expenses, you should determine whether you’re
already likely to be subject to the AMT — or whether the actions you’re considering might
trigger it. Deductions used to calculate regular tax that aren’t allowed under the AMT can trigger AMT liability. Some income items also might trigger or increase AMT liability:
• Long-term capital gains and dividend income, even though they’re taxed at the same rate for both regular tax and AMT purposes,
• Accelerated depreciation adjustments and related gain or loss differences when assets are sold, and
• Tax-exempt interest on certain private-activity municipal bonds.
Finally, in certain situations incentive stock option (ISO) exercises can trigger significant AMT liability.
If you pay AMT in one year on deferral items, such as depreciation adjustments, passive activity adjustments or the tax preference on ISO exercises, you may be entitled to a credit in a subsequent year. In effect, this takes into account timing differences that reverse in later years.
Avoiding or reducing AMT
If your income is high enough that you’re at AMT risk for 2019 or 2020, with proper planning, you may be able to avoid the AMT, reduce its impact or even take advantage of its lower maximum rate. (See the Chart “2019 individual income tax rate schedules.”)
To determine the right timing strategies for your situation, work with your tax advisor to assess whether:
You could be subject to the AMT this year. Consider accelerating income and short-term capital gains into this year, which may allow you to benefit from the lower maximum AMT rate. Also consider deferring expenses you can’t deduct for AMT purposes until next year — you may be able to preserve those deductions (but watch out for the annual limit on the state and local tax deduction).
Additionally, if you defer expenses you can deduct for AMT purposes to next year, the deductions may become more valuable because of the higher maximum regular tax rate. Finally, carefully consider the tax consequences of exercising ISOs.
You could be subject to the AMT next year. Consider taking the opposite approach. For instance, defer income to next year, because you’ll likely pay a relatively lower AMT rate. Also, before year end consider selling any private activity municipal bonds whose interest could be subject to the AMT.
In addition to income tax, you must pay Social Security and Medicare taxes on earned income, such as salary and bonuses. The 12.4% Social Security tax applies to earned income up to the Social Security wage base of $132,900 for 2019 (up from $128,400 for 2018). All earned income is subject to the 2.9% Medicare tax. Both taxes are split equally between the employee and the employer.
If you’re self-employed, your employment tax liability typically doubles, because you also must pay the employer portion of these taxes. The employer portion of self-employment taxes paid (6.2% for Social Security tax and 1.45% for Medicare tax) is deductible above the line.
As a self-employed taxpayer, you may benefit from other above-the-line deductions as well. You can deduct 100% of health insurance costs for yourself, your spouse and your dependents, up to your net self-employment income. You also can deduct contributions to a retirement plan and, if you’re eligible, an HSA for yourself. And you might be able to deduct home office expenses. Above-the-line deductions are particularly valuable because they reduce your AGI and, depending on the specific deduction, your modified AGI (MAGI), which are the triggers for certain additional taxes and the phaseouts of many tax breaks.
Additional 0.9% Medicare tax
Another employment tax that higher-income taxpayers must be aware of is the additional 0.9% Medicare tax. It applies to FICA wages and self-employment income exceeding $200,000 per year ($250,000 for married filing jointly and $125,000 for married filing separately).
Note that there’s no employer portion of this tax. So unlike the Social Security tax and the regular Medicare tax, the additional Medicare tax doesn’t double for the self-employed. But this also means that no portion of the tax is deductible above the line against self-employment income.
If your wages or self-employment income varies significantly from year to year or you’re nearing the threshold for triggering the additional Medicare tax, income timing strategies may help you avoid or minimize it. For example, if you’re an employee, perhaps you can time when you receive a bonus, or you can defer or accelerate the exercise of stock options. If you’re self-employed, you may have flexibility on when you purchase new equipment or invoice customers. If you’re a shareholder-employee of an S corporation, you might save tax by adjusting how much you receive as salary vs. distributions.
Also consider the withholding rules. Employers are obligated to withhold the additional tax beginning in the pay period when wages exceed $200,000 for the calendar year — without regard to an employee’s filing status or income from other sources. So your employer might withhold the tax even if you aren’t liable for it — or it might not withhold the tax even though you are liable for it.
If you don’t owe the tax but your employer is withholding it, you can claim a credit on your income tax return for the year the tax was withheld. If you do owe the tax but your employer isn’t withholding it, consider filing a W-4 form to request additional income tax withholding, which can be used to cover the shortfall and avoid interest and penalties. Or you can make estimated tax payments.
Employment taxes for owner-employees
There are special considerations if you’re a business owner who also works in the business, depending on its structure:
Partnerships and limited liability companies. Generally, all trade or business income that flows through to you for income tax purposes is subject to self-employment taxes — even if the income isn’t actually distributed to you. But such income may not be subject to self-employment taxes if you’re a limited partner or an LLC member whose ownership is equivalent to a limited partnership interest. Whether the additional 0.9% Medicare tax on earned income or the 3.8% net investment income tax (NIIT) will apply also is complex to determine. So, check with your tax advisor.
S corporations. Only income you receive as salary is subject to employment taxes and, if applicable, the 0.9% Medicare tax. To reduce these taxes, you may want to keep your salary relatively — but not unreasonably — low and increase the income that is taxed to you through your Schedule K-1 by virtue of your share of the earnings from the business. That income isn’t subject to the corporate level tax or the 0.9% Medicare tax and, typically, is not subject to the 3.8% NIIT. Plus, you may be able to benefit from the Section 199A deduction on the K-1 earnings.
C corporations. Only income you receive as salary is subject to employment taxes and, if applicable, the 0.9% Medicare tax. Nonetheless, you may prefer to take more income as salary (which is deductible at the corporate level) as opposed to dividends (which aren’t deductible at the corporate level yet are still taxed at the shareholder level and could be subject to the 3.8% NIIT) if the overall tax paid by both the corporation and you would be less.
Warning: The IRS scrutinizes corporate payments to shareholder-employees for possible misclassification, so tread carefully.
Estimated payments and withholding
You can be subject to penalties if you don’t pay enough tax during the year through estimated tax payments and withholding. Here are some strategies to help avoid underpayment penalties:
Know the minimum payment rules. For you to avoid penalties, your estimated payments and withholding must equal at least 90% of your tax liability for the year or 110% of your tax for the previous year (100% if your AGI for the previous year was $150,000 or less or, if married filing separately, $75,000 or less). Warning: Watch out for under withholding. See “What’s new! Under withholding may still be a risk.”
Use the annualized income installment method. This method often benefits taxpayers who have large variability in income by month due to bonuses, investment gains and losses, or seasonal income (especially if it’s skewed toward the end of the year). Annualizing computes the tax due based on income, gains, losses and deductions through each estimated tax period.
Estimate your tax liability and increase withholding. If as year-end approaches you determine you’ve underpaid, consider having the tax shortfall withheld from your salary or year-end bonus by December 31. Because withholding is considered to have been paid ratably throughout the year, this is often a better strategy than making up the difference with an increased quarterly tax payment, which may still leave you exposed to penalties for earlier quarters.
Warning: You also could incur interest and penalties if you’re subject to the additional 0.9% Medicare tax and it isn’t withheld from your pay and you don’t make sufficient estimated tax payments.
The U.S. Department of Labor (DOL) has released a final rule to increase the minimum salary required to qualify for certain overtime exemptions. The final rule takes effect January 1, 2020. The DOL estimates that the changes will make about 1.2 million workers newly eligible for overtime, unless employers increase their salaries.
The Fair Labor Standards Act (FLSA) requires virtually all employers to pay most employees at least the federal minimum wage for each hour worked, as well as overtime pay for all hours worked in excess of 40 in a workweek. The FLSA allows for exemptions from these overtime and minimum wage requirements for certain “exempt” administrative, professional, and executive employees. To be considered “exempt,” these employees must generally satisfy specific salary and duties tests:
Meet the minimum salary requirement (currently $455 per week);
With very limited exceptions, the employer must pay the employee their full salary in any week they perform work, regardless of the quality or quantity of the work; and the employee’s primary duties must meet certain criteria.
There is also a special exemption for “highly-compensated employees” who are paid a total annual compensation of at least $100,000 and customarily and regularly perform at least one of the exempt duties of an exempt executive, administrative, or professional employee.
Overtime Rule History:
In 2016, the DOL published a final rule that would have raised the minimum salary requirement for the administrative, professional, and executive exemptions to $913 per week, but a court blocked that rule from taking effect.
On March 7, 2019, the DOL released a proposed rule that would have more modestly increased the minimum salary requirement for these exemptions.
DOL Releases Final Rule Effective January 1, 2020:
Minimum Salary Requirement:
Effective January 1, 2020, the minimum salary requirement for the administrative, professional (including the salaried computer professional), and executive exemptions will increase from $455 per week to $684 per week (equivalent to $35,568 per year).
This means that in order to qualify for an administrative, professional, and executive exemption from FLSA’s overtime requirements, employees must be paid a weekly salary of at least $684 and continue to satisfy the applicable duties tests. Exempt computer employees may also be paid hourly, if it is at least $27.63 per hour, which doesn’t change under the new rule.
Inclusion of Nondiscretionary Bonuses in Minimum Salary Requirement:
Beginning January 1, 2020, employers will be allowed to use nondiscretionary bonuses, incentive payments, and commissions to satisfy up to 10 percent of the minimum salary requirement for the administrative, professional, and executive exemptions, as long as these forms of compensation are paid at least annually.
The final rule permits employers to make a final “catch-up” payment within one pay period after the end of year to bring an employee’s compensation up to the required level. For example, if an employer chooses this option, each pay period, the employer must pay their exempt executive, administrative, or professional employee at least 90 percent of the salary level ($615.60 per week). Then, if at the end of year, the employee’s paid-out salary plus the nondiscretionary bonuses and incentive payments (including commissions) does not equal at least $35,568, the employer would have one pay period to make up for the shortfall.
Highly Compensated Employee Exemption:
The final rule increases the total annual compensation requirement for the “highly compensated employee” exemption to $107,432 per year (at least $684 must be paid on a weekly salary basis).
For the highly compensated employee exemption, employers are already allowed to include commissions, nondiscretionary bonuses, and other nondiscretionary compensation toward meeting the total annual compensation requirement, but there is no 10 percent cap like the other exemptions. This won’t change under the new rule. Thus, as long as the employer pays the employee at least $684 on a weekly salary basis, the employer will be able to count these other forms of compensation toward meeting the minimum total compensation requirement ($107,432 per year).
No Changes to Duties Tests:
The DOL didn’t make changes to the duties tests.
Future Minimum Salary Increases:
The DOL intends to update the minimum salary requirements more regularly, using the same rulemaking process, which involves publication in the federal register and an opportunity for public comment.
Employers should evaluate the potential impact on their business now. This includes identifying those employees who currently earn less than $35,568 annually and are exempt from overtime. If your exempt employees fall below the new salary threshold, you would have two options:
Reclassify the employees as non-exempt and pay them overtime whenever they work more than 40 hours in a workweek; or raise their salary to meet the new requirement.
Note: Some states have their own salary requirements that already exceed the new federal rule. Some other states may decide to increase their salary thresholds based on the new federal rule. Review both federal and state law to determine whether an employee may be classified as exempt from overtime. If an employee is covered by both the federal and state law but doesn’t meet both sets of tests, consult with counsel to determine how you should classify the employee in that particular situation.
Many people have accumulated significant balances in tax deferred retirement accounts during their working years. In addition, they may have accumulated significant additional assets and, therefore, do not currently need withdrawals from their tax deferred accounts. Nonetheless, U.S. tax law requires distributions from these accounts beginning at age 70 1/2, whether or not the funds are needed.
There are many rules that can trip up the unwary and subject account holders to penalties if distributions are not taken in a timely manner. Smart planning for these distributions may result in tax efficient strategies to minimize the tax bite.
What is a Required Minimum Distribution?
A Required Minimum Distribution (RMD) is generally the minimum amount that must be withdrawn from your retirement plans each year once you reach age 70 1/2.
These rules apply to traditional IRAs, SEP IRAs, Simple IRAs, SARSEPs, and employer-sponsored plans including 401(k)s, 403(b)s and 457 plans. RMDs are not required for Roth IRAs while the account owner is living, but they do have to be taken from Roth 401(k)’s. By rolling over your Roth 401(k) to a Roth IRA you could avoid the need to take the RMD since Roth IRA’s are not subject to the minimum distribution rules while the account owner is living.
When must the RMDs begin?
Distributions typically begin in the year the account owner turns 70 1/2. However, the first distribution may be delayed until April 1 of the calendar year following the later of:
1. The year the plan owner turns 70 1/2, or
2. The calendar year the employee retires.
If the plan is an IRA or if the account owner is at least a 5% owner of a business, distributions must begin by April 1 of the year after the account holder is 70 1/2, even if the owner is still working.
Delaying the first payment until April 1 of the year after the owner turns 70 1/2 will require two distributions in that calendar year. The first distribution will pertain to the prior year when the recipient attains age 70 1/2, and the second distribution will be the normal annual distribution. As a result of taking two distributions in one year, this delay may bump plan owners into a higher tax bracket; therefore, depending on earnings, it may make sense to take the first distribution in the year the account owner turns 70 1/2. Be sure to consult your tax advisor to assist with this decision.
How is the RMD calculated?
The account balance is typically paid to the account owner over the life expectancy of the participant according to tables provided by the IRS. The RMD must be taken every year and it is up to the account owner to be sure the correct amount is withdrawn. The distribution is determined based on the balance in the account at December 31 of the prior year. This balance is then divided by life expectancy to determine the RMD, which must be taken by December 31 of the current year.
Age of account owner on December 31, 2018: 70 1/2
Account balance on December 31, 2018: $100,000
Life Expectancy per IRS Table: 27.4
2019 RMD: $3,650
The RMD must be calculated separately for each IRA; however, the total can be withdrawn from one or more IRAs.
Taxation of RMDs
Distributions may be partly taxable or fully taxable as ordinary income in the year received depending on whether there were nondeductible contributions made to the account. (Nondeductible contributions to IRA’s give you basis in the account and are tracked on Form 8606).
If all contributions were deducted in the years they were made then the entire distribution will be taxable. If non-deductible contributions were made then a pro rata portion of each distribution represents a return of basis and is tax-free.
TAX PLANNING OPPORTUNITIES
Qualified Charitable Distributions
If the IRA owner is age 70 ½ or older, a distribution of up to $100,000 can be directed each year to a charity, and the amount will not be included in taxable income. These types of distributions can be used to satisfy part or all of the RMD for the year. The contribution will not be allowable as an itemized deduction, since it is not included in income. (This may be moot, since many individuals are not eligible to itemize deductions as a result of the changes implemented by the Tax Cuts and Jobs Act).
In addition, since the charitable distribution is not included in taxable income, certain deductions and credits based on income will not be impacted. For example, the amount of taxable social security benefits, the cost of Medicare benefits, or state income tax when it is calculated based on adjusted gross income would not be impacted when a distribution is not included in income.
The distribution must be made by the trustee of the IRA to the charity by December 31. The trustee should issue the check directly to the charity, if possible. These types of distributions cannot be made to donor advised funds, private foundations, or supporting organizations.
RMDs are not required for Roth IRAs while the account owner is living. Therefore, in certain circumstances it may make sense to convert part or all of a traditional IRA to a Roth IRA so that RMDs will not be required. This strategy could be employed in the years following retirement but prior to reaching age 70 1/2. There are many things to be considered before converting to a Roth, since there will be taxable income in each year of the conversion. However, there may be other deductions that could offset the taxable income such as alimony payments or a large charitable contribution of appreciated property. In addition, the impact of Medicare premiums should be considered.
Putting the RMD Puzzle Together
There are a variety of considerations with respect to RMDs, such as:
The year the RMDs should begin;
Calculating the amount of the RMD;
Impact on taxable income;
Basis in the IRA;
The feasibility of Roth conversion; and
Qualified donations to charity.
For questions or assistance in computing or determining whether to take a minimum distribution, contact us.