Planning for income and deductions can be a challenge post-TCJA
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. (See the Chart “2019 individual income tax rate schedules.”) 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 phaseouts and other limits can reduce or eliminate the benefits of these breaks, effectively increasing your marginal tax rate.
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. (See the Chart "2019 standard deduction" for the 2019 amounts.) 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.
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 (see “Early withdrawals”) and aren’t required (see “Required minimum distributions”).
And here are some potentially controllable expenses:
- State and local income taxes,
- Property taxes,
- Mortgage interest,
- Margin interest, and
- Charitable contributions.
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.
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 would have returned to 10% on your 2019 tax return if Congress hadn’t extended the 7.5% floor.
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.
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.
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 foryourself. 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.
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.
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.
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 underwithholding. See “What’s new! Underwithholding 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.