Get a jump on your End-of-year Tax Planning
You might recall that the big new tax law—known officially as the Tax Cuts and Jobs Act (TCJA), signed into law in December 2017—took effect at the beginning of the 2018 tax year. Among its major adjustments, the TCJA almost doubled the standard deduction, lowered tax brackets, repealed the Affordable Care Act’s individual mandate, and limited the deductions for state and local income taxes (SALT), as well as for primary residence mortgage interest.
This law was the most significant change to the tax code in over three decades, and has impacted almost every American’s finances in one way or another. Not all the old pre-TCJA tax advice applies in this new tax environment. Here are five strategies for making the most of the new tax law:
Make Charitable Donations via QCDs
Anyone who is over the age of 70½ is now strongly advised to make any substantial charitable donations (say $1,000 or more) by using “Qualified Charitable Distributions” (QCDs), rather than writing checks to charities. Since anyone over the age of 70½ must take Required Minimum Distributions (RMDs) from their IRAs each year, it makes sense to do so in the most tax efficient way possible.
Here’s how a QCD works. Essentially, it is a transfer directly from your IRA to a qualified charity. Money donated to charity via a QCD counts towards your RMD for that year, but you don’t have to pay tax on the QCD portion of the RMD. Just notify your financial advisor or IRA custodian that you wish to make a QCD, and they’ll provide you with the paperwork necessary to do so.
Why go to the trouble? Because new itemization rules mean that you may receive less (or no) tax benefit from writing checks directly to charity. Making donations from your IRA via a QCD, on the other hand, works for everyone; it directly reduces your taxable income by the entire amount of the QCD (up to $100,000 per year).
Let’s say you are a 71-year-old single taxpayer, and you expect to have $120,000 of taxable income this year, of which $40,000 is the RMD from your IRA. Let’s also say that you intend to donate $30,000 to your favorite charity. As you can see in this table, if you use a QCD for the donation, only $10,000 of your $40,000 RMD will be taxable. That means your taxable income would be: $90,000 (instead of $120,000), minus the $12,000 “standard deduction” ($24,000 for married couples) that you get if you don’t itemize, resulting in taxable income of only $78,000.
In contrast, if you write a check to the charity for your donation, without doing a QCD, you’d have: $120,000 of taxable income, minus the $30,000 charitable donation as an itemized deduction, but you wouldn’t receive the $12,000 standard deduction. Thus, barring other itemized deductions, you’d be taxed on $90,000 of income rather than $78,000.
While the net tax impact depends on your own individual tax bracket, a rough estimate is that a person in the scenario described above would save about $2,600 by making their donation with a QCD.
Get mortgages on rental properties instead of on your primary residence
If you need to borrow money, one way is to obtain a mortgage on your primary residence (defined as the residence where you usually live—you can only have one primary residence at a time). However, depending on whether you itemize and the amount of the mortgage, that mortgage interest might not be entirely tax deductible any more, and if it’s a HELOC, none of the interest is deductible. On the other hand, mortgage interest on a rental property mortgage will be fully tax deductible because it is an expense of your rental business.
Withdraw more from your individual retirement accounts (IRAs)
One of the key elements of the new tax law is that tax brackets across the board are lower. If you don’t expect significant changes in income in coming years, you may never be in a lower bracket than now, so if you are over the age of 59½ (or if you have a parent in this situation), you may want to use up all of your current tax bracket by strategically creating extra taxable income from your 401k or IRA. That is especially true if you (or your parent) is in the lowest brackets, where you may want to take maximum advantage of those low tax rates.
Let’s say, for instance, that you’re married filing jointly and have $60,000 of taxable income. This puts you in the 12% marginal tax bracket, meaning each additional dollar of taxable income will cost 12 cents in (Federal) income tax. The 12% bracket goes up to $77,400, where the 22% bracket kicks in (on income above that amount, up to $165,000). Since your taxable income is $17,400 below the top of the 12% bracket, you might want to consider withdrawing an extra $17,400 from your IRA (which will be taxed at 12%) in order to “use up” all of that 12% bracket. If your elderly parent is in the 12% bracket, and you (and your siblings) are in higher brackets, getting some extra money out of their IRA makes a lot of sense; remember, if you inherit that IRA, you’ll be forced to take money out each year, and it will be taxed at your highest marginal tax bracket.
Look at it this way
- The government let you put money into your IRA or 401(k) over the years, when you were probably in a higher tax bracket;
- That money has now grown for many years tax-deferred;
- If they’ll let you now take money out and only pay 12 cents of each dollar in taxes, that’s a pretty good deal;
- Once you withdraw the funds, you’ve eliminated the tax burden on that money;
- You can then use the funds to build up your after-tax (non-IRA) investments.
Consider incorporating yourself rather than working as an employee
Another notable element of the new tax law is that many business owners are eligible for a new 20% reduction of their business’ taxable income. For this reason, you might want see if your employer would be willing to let you leave your firm and use a pass-through entity to accomplish your work (e.g., a Sub-S Corp or LLC). This won’t work in all situations, whether for liability reasons, excluded business activities or otherwise, but it is certainly worth exploring.
While the 20% income reduction makes becoming an independent contractor more enticing, there are numerous other considerations. There are limits on the types and amounts of income your business can generate in order to qualify for the 20% break. For instance, your income must be below $157,500 if you are single, or $315,000 if you are married. There are also other requirements, limits, and costs involved in starting a business and becoming an independent contractor. For one thing, the independent contractor has to pay Social Security and Medicare taxes that their employer was previously paying, as well as health insurance and other employee benefits their employer may have been paying. Those extra taxes and other costs must be weighed against the new tax law’s 20% deduction that the independent contractor might enjoy. Nevertheless, these hurdles may now be worth navigating, since that 20% deduction can be quite a significant incentive.
Seek professional advice
Making the right financial decisions—that take into account your circumstances, plus the many details of the new tax law—can be challenging. This summary is meant to serve as general information; we encourage you to seek advice from your tax and financial advisors regarding strategies that might be most beneficial to you. Everyone’s situation is unique, and your financial picture should be considered before making such decisions. If we can be of service to you in this endeavor, please remember that Viridian provides both tax and comprehensive financial planning solutions.
Viridian is an SEC Registered Investment Advisor (RIA) with clients across the United States. Viridian offers financial planning, investment management, and tax services (through its sister company, Viridian Tax and Accounting).