The Tax Cuts and Jobs Act is the most significant set of changes to the U.S. tax code in several decades. The vast majority of the changes go into effect for the 2018 tax year, which is the return that you'll file with the IRS in the spring of 2019.
Here's a rundown of what Americans need to know about the recent tax changes that could affect individual taxpayers in the upcoming tax season. Changes made on the corporate side won't affect your tax return, so we'll focus on the individual filer. These changes, which are mandated by the new tax legislation for individual filers, are set to expire in 2025, unless they get extended. (Corporate changes made by the bill are permanent.)
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Tax brackets -- Still seven, but with different rates
One of the headline changes made by the Tax Cuts and Jobs Act was a general lowering of U.S. tax rates. While the number of tax brackets remained at seven, the rates were generally lowered, with the exception of the minimum tax rate staying at 10% for the poorest Americans.
In addition to lower tax rates, the income thresholds were increased, particularly at the higher tax brackets. In other words, the highest tax brackets now apply to fewer (higher-earning) Americans than it did previously. For example, before the passage of the Tax Cuts and Jobs Act, the top tax rate was 39.6% and applied to married couples filing jointly who earned more than $480,050. With tax reform, that top rate was lowered to 37% and only applies to married couples making more than $600,000 in taxable income, much more income than before.
Here's a look at the tax brackets in effect for the 2018 tax year, which will apply to the next tax return you'll file in 2019.
Additionally, the IRS recently announced the updated inflation-adjusted 2019 tax brackets, which will be used on the tax return you'll file in 2020 for income you'll earn during the 2019 calendar year:
Annual adjustments will be different
Before the 2018 tax year, inflation adjustments to things like the tax brackets, standard deduction, and other tax provisions had been based on the CPI-U (consumer price index for all urban consumers). This index tracks a basket of goods and services that affects the typical U.S. household, so it made sense that it was used to gradually increase tax-related figures over time.
The new tax law uses a metric known as the Chained CPI instead, which makes the assumption that if a particular good or service becomes too expensive, consumers will begin buying a cheaper alternative. Without getting too deep into a discussion about the Chained CPI, the effect is that the index grows at a slightly slower rate over time than other forms of the CPI.
This is a relatively subtle change and unlikely to have a big impact on a year-to-year basis. However, because Chained CPI increases at a slower pace over time, it could have a big impact on the inflation adjustments to the tax code over decades. Simply put, the long-term effect of this means that the higher tax brackets will begin to apply to lower-income taxpayers, as real inflation will (theoretically) rise faster than the income thresholds of the marginal tax brackets.
Higher standard deduction
The Tax Cuts and Jobs Act nearly doubled the standard deduction from previous levels. Taxpayers can choose between using the standard deduction or itemized deductions. Itemizing deductions means adding up all of the individual tax deductions to which you're entitled and then subtracting them from your adjusted gross income (AGI). (Note: Adjusted gross income is your total income minus a few adjustments. Common adjustments to income include traditional IRA contributions and student loan interest, just to name a few.)
On the other hand, the standard deduction simply is a set amount that Americans can choose to deduct instead. Taxpayers can use whichever of the two methods is more beneficial to them.
The majority of U.S. households use the standard deduction, so this change will certainly affect millions of people.
With that in mind, here's a comparison of the standard deductions that were in place for the 2017 tax year and those now in effect for 2018 and 2019:
The effect of this change is that more Americans will end up using the standard deduction on their returns beginning in 2019 when they file for the 2018 tax year. Historically, approximately 70% of individual tax returns used the standard deduction, while the other 30% found it more beneficial to itemize. For 2018 and beyond, experts have projected that roughly 95% of individual tax returns now will utilize the standard deduction.
The personal exemption is gone
To be perfectly clear, although the standard deduction has roughly doubled, it doesn't mean that people are getting double the tax break -- far from it, actually.
While the standard deduction has increased, the valuable personal exemption has gone away. The reasoning for this is that, in addition to a tax cut, lawmakers were also attempting to simplify the tax code. So instead of giving taxpayers a standard deduction and a number of exemptions, these two things were essentially combined into a higher standard deduction.
In plain English, a personal exemption is a certain amount of income Americans can exclude from their taxable income each year. In prior tax years, Americans could claim one personal exemption for themselves, their spouse, and one for each dependent.
In the 2017 tax year, each personal exemption was an effective $4,100 tax deduction. And there was no limit to the number of personal exemptions that could be claimed. For example, a married couple with six dependent children could claim eight personal exemptions. You can see how the higher standard deduction may not exactly be a gift -- especially for larger families.
The Child Tax Credit has doubled
Although families with several children may feel the sting from the repeal of the personal exemption, there's some good news. Not only has the Child Tax Credit been increased, but more of the credit now is refundable and the income limitations are far less restrictive.
Briefly, it's important to mention that a credit is very different from a deduction. While a deduction lowers the amount of income that the government considers when taxing you, a tax credit actually reduces the amount of tax you owe, dollar for dollar. If you owe $1,000 in tax, a $1,000 credit would pay it off for you while a deduction just would lower the income level that your tax rate would apply to. In other words, a $1,000 credit is far more valuable than a $1,000 deduction.
Tax reform was good for the Child Tax Credit, which was doubled to $2,000 per qualifying child under age 17. As much as $1,400 of this amount is refundable -- meaning that it can be claimed even if the taxpayer's federal income tax liability is already zero. So even if a parent has little income or otherwise owes no federal income taxes, they could still take advantage and get this money back.
Furthermore, the income phase-out thresholds are significantly higher than the previous levels, which makes the credit available to far more Americans than in previous years. Several tax breaks phase out above certain income levels. The reason is that many tax benefits are intended to benefit low- to moderate-income taxpayers, not the rich. However, the range of people who can benefit from the Child Tax Credit has been significantly expanded.
Most education tax breaks remain
The two popular tax credits for college expenses, the American Opportunity Credit and the Lifetime Learning Credit, both survived tax reform unscathed. These are designed to lower the tax bills of people who paid college tuition. The American Opportunity Credit applies to tuition paid toward a degree or certificate program but only for the first four years of college, while the Lifetime Learning Credit applies to nearly all tuition and fees.
However, it's worth noting that the tuition and fees tax deduction is no longer available, as the Bipartisan Budget Act of 2018 only made it available through the 2017 tax year -- although it's possible that Congress will still choose to extend it. Previously, certain taxpayers who couldn't qualify for one of the two credits could deduct as much as $4,000 worth of tuition and fees as an adjustment to income. Now, taxpayers who can't qualify for either credit are out of luck.
Expanded use of 529 savings plans
The two main college savings accounts, 529 savings plans and Coverdell Education Savings Accounts, or ESAs, both remain in the revised tax code. These accounts provide a tax-advantaged way for parents and other relatives to save and invest money for educational expenses such as tuition, fees, books, and certain other qualifying expenses. While there's no deduction for contributions to these accounts on federal tax returns, any money these accounts earn from investments can be withdrawn tax-free when used for a qualified expense.
However, a change was made to 529 savings plans to allow use of the funds for qualifying educational expenses at any level, not just for college. This was already the case with Coverdell ESAs. As one potential example, if you end up sending your child to a private high school, you could potentially use funds from their 529 savings plan to help pay for it.
Mortgage interest still is deductible, but...
The deduction for mortgage interest is one of the most popular U.S. tax breaks. In fact, tax benefits like these are often a primary reason Americans decide to buy a home. Fortunately for many homeowners, the mortgage interest deduction survived the tax reform efforts, but it did receive two major modifications.
First, the cap (or limit) on the total deduction allowed has been reduced to the interest on up to $750,000 of qualified residence debt, or mortgage principal on a primary or secondary home. This is down from the previous limit of $1 million, although mortgages obtained before December 15, 2017 are grandfathered in to the higher limit.
Second, the previous additional limit that allowed taxpayers to deduct interest on as much as $100,000 of home equity debt has been eliminated. To be clear, interest on a home equity loan (such as a HELOC) may still be used as a deduction, but if and only if the loan was used to substantially improve your home. In this case, it becomes qualified residence debt and is counted as part of your $750,000 cap.
The charitable contributions deduction is another wildly popular tax break and was never really on the chopping block. In fact, highly charitable taxpayers can now deduct donations of as much as 60% of their AGI -- a boost from the previous 50% maximum.
One potential negative change, however, is that donations made regularly to colleges and universities in exchange for the right to purchase athletic tickets are no longer deductible.
The medical expense deduction is lower for 2018, but...
The Tax Cuts and Jobs Act lowered the threshold for medical expense deductions to 7.5% of AGI from the prior threshold of 10%. In other words, a taxpayer with an AGI of $100,000 can now deduct medical expenses exceeding $7,500. The IRS has a long list of expenses that qualify as "medical expenses," so it can be a good idea to start keeping track of yours if you think you may qualify.
However, this change only was made for the 2017 and 2018 tax years. So you'll be able to take advantage of it on the tax return you file in 2019. Beyond that time, however, the threshold is set to increase to 10% again unless Congress acts to extend it.
The SALT deduction: Bad news for high-tax states
The biggest tax deduction by dollar amount that Americans have taken advantage of in recent years is the deduction for state and local taxes -- also known as the SALT (State and Local Taxes) deduction. Specifically, Americans have been able to deduct the following:
- State and/or local property taxes, such as those paid on a personal residence, automobile, or other personal property.
- State and local income taxes or state sales taxes, whichever results in the larger deduction. Generally speaking, income taxes are the better deduction, but the option to deduct sales tax allows residents of states without an income tax to benefit, as well. If you choose the sales tax option, you don't need receipts -- the IRS provides a calculator to determine this deduction.
Starting with the 2018 tax year, however, the SALT deduction is limited to a total of $10,000. This may sound like a lot, but many Americans -- especially those in high-tax states like New York, New Jersey, and California -- have been deducting several times this amount. For example, the property tax on my parents' modest home in New Jersey almost reaches the $10,000 cap all by itself.
Now, millions of Americans cannot deduct their state and local taxes, and on top of that, the higher standard deduction means that many families who pay high amounts of state and local taxes may not be able to take advantage of the SALT deduction at all.
No more Obamacare penalties, starting in 2019
While the Republican administration and Congress have thus far been unsuccessful in repealing the Affordable Care Act, the Tax Cuts and Jobs Act did eliminate the individual mandate -- aka the "Obamacare penalty." This is the penalty you pay for not having health insurance.
One important caveat: The penalty is only repealed in tax years 2019 and beyond. If you didn't maintain qualifying health coverage throughout 2018, you still may face the penalty when you file your tax return in 2019.
The new pass-through income deduction
Designed as a tax break for small business owners, the Tax Cuts and Jobs Act includes a 20% deduction for "pass-through" income. This includes income you receive from a sole proprietorship or other pass-through entities such as partnerships, LLCs, and S-Corps. Real estate income counts, as do dividends you receive from REIT (Real Estate Investment Trust) stocks.
There's one notable restriction. The new law sets a maximum amount of income people in "professional services" businesses, such as lawyers, doctors, and consultants, can earn while still taking advantage of the deduction. For the 2018 tax year, the pass-through deduction for these types of business starts to phase out at an AGI greater than $157,500 (single filers) or $315,000 (married filing jointly).
Big changes to the alternative minimum tax
Many legislators had initially sought a repeal of the Alternative Minimum Tax, or AMT, but it still exists in 2018 and beyond. If you aren't familiar with it, the AMT is designed to ensure that high-income taxpayers pay their fair share of taxes, even if they're entitled to tons of deductions and credits.
Taxpayers still need to calculate their taxes twice -- once under the standard method and again using the AMT -- and pay whichever results in a larger bill. Don't worry, though -- your tax-preparation software program will determine if you need to be concerned about the AMT. However, there were a couple of significant changes made by the new tax law.
First, AMT exemptions never were indexed for inflation. This became the main problem with the AMT -- because it didn't change over time with purchasing power, it began to apply to more and more Americans. The AMT never was designed to affect the middle class, but it had started to do just that. From here on out, the AMT exemption amounts will be indexed for inflation.
Second, the AMT exemption amounts themselves, as well as the phase-out limits at which they start to go away, have been increased significantly. Here's a look at the AMT exemptions for the 2017-2019 tax years:
And finally, here's how dramatically the exemption phase-out income thresholds have changed:
The estate tax applies to even fewer American families now
To be perfectly clear, the estate tax, which is essentially a tax on inherited wealth, only applied to the wealthiest U.S. households, even before the Tax Cuts and Jobs Act was passed. However, the new law makes it apply to even fewer filers.
Under the former tax law, the estate tax only applied to the portion of an estate that was in excess of $5.59 million (2018). The new law doubled the threshold to $11.18 million for 2018 and will increase again in 2019.
Which tax deductions are gone?
As we've seen, many tax deductions survived the passage of the Tax Cuts and Jobs Act, either in their previous form or with modifications. On the other hand, there are some that didn't get to remain on the books at all. Remember, the goal of the tax reform effort wasn't just to cut taxes but to simplify the U.S. tax code, as well. As part of the simplification, several deductions got axed.
Here are the most significant tax breaks that Americans can no longer take advantage of:
- Moving expenses -- This was an above-the-line deduction, meaning that it could be taken whether or not a taxpayer itemized, and was designed to offset the costs of job-related moving expenses. Now, this deduction is gone, except for certain moves related to active-duty military service.
- Casualty and theft losses -- If your home was burglarized, you formerly were able to deduct the value of the stolen items. Now, the deduction only can be used for losses attributed to a federally declared disaster.
- The "miscellaneous deduction" category -- This is one true simplification to the tax code. There used to be a long list of deductions that Americans could take advantage of, to the extent that they exceeded 2% of AGI. This included things like unreimbursed employee expenses, tax preparation expenses, and more. Starting with the 2018 tax year, these deductions are gone, so some taxpayers with lots of these expenses may feel the sting from this.
Which tax breaks stay the same in 2019?
As I mentioned, many tax breaks survived the Tax Cuts and Jobs Act unscathed. This is not an exhaustive list, but here are some tax deductions and credits that weren't affected at all:
- Capital gains and qualified dividend taxes
- The Child and Dependent Care Credit
- The American Opportunity Credit
- The Lifetime Learning Credit
- The Student Loan Interest deduction
- Tax deductions for retirement savings
Will these tax changes expire after 2025 or will Congress make them permanent?
One big uncertainty is what will happen to the Tax Code after 2025. The way the Tax Cuts and Jobs Act is set up, the changes to the corporate side of the tax code are permanent, but the individual tax changes are mostly set to expire after the 2025 tax year. The most significant exception is the change from the CPI-W to the Chained CPI when it comes to calculating inflation -- that one's a permanent change.
Here's the problem. If the tax changes expire as scheduled after 2025 and our individual tax code reverts back to its previous form, the lower inflation calculation will effectively make taxes even higher than they were before for most Americans.
There's currently an effort underway to make the changes permanent (lawmakers refer to this as part of "Tax Reform 2.0"). However, with a split Congress, any further tax bills are likely to face an uphill battle.
Seem like too much to digest? Don't fret
Admittedly, these changes may sound a little complicated. However, the good news is that if you use tax preparation software or have your taxes done by a professional, you don't need to worry too much about them. They'll ensure you're following the updated tax code and will calculate the effect of these changes on your wallet.
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