Part of the IRS headquarters building (Photo: Allison Bell/TA) (Photo: Allison Bell/TA)

With year-end fast approaching, savvy advisors will once again be working closely with clients to create a tax strategy that minimizes their tax liability.

With the passage of the Tax Cuts and Job Act (TCJA) last year, and more advisors moving toward a holistic financial planning model in their practice, tax planning has become increasingly important.

Changing income tax rates and a shift from accumulation to income investing as baby boomers near and enter retirement requires periodic review of clients’ current tax situation.

(Related: New Tax Deduction Might Favor Life Agents Over Retirement Advisors)

While Prudential Financial, its affiliates, and their financial professionals do not render tax or legal advice, and advisors and clients alike should always consult with their tax and legal advisors regarding their personal circumstances, here are six topics advisors should consider under the new TCJA tax regime.

1. Take advantage of the lower tax rates.

In general, marginal tax rates fell at all income levels under the Tax Cuts and Jobs Act of 2018 except for married couples filing jointly making between $400,000 and $424,950 and single filers between $200,000 and $424,950, where the marginal rate increased from 33% to 35%. Not only are the tax rates lower but the tax brackets are adjusted so it generally takes more income to get to the next bracket. Taxpayers can take advantage of the lower tax rates and further reduce their taxable income by:

  • Increasing contributions to employer-sponsored retirement plans, such as 401(k) and 403(b) plans to reach the $18,500 contribution maximum by year’s end.
  • Contribute $5,500 to individual retirement accounts (IRAs) — don’t overlook the ability of a non-working spouse to do the same.
  • Take advantage of catch-up contributions for IRAs and employer-sponsored retirement plans (e.g., 401(k) and 403(b) plans) for clients ages 50 and older.
  • For those who participate in a high-deductible health plan, contribute the maximum of $3,450 single or $6,900 family to a health savings account (HSA).

2. Plan ahead if itemizing deductions.

Most taxpayers in 2018 will likely take advantage of the higher standard deduction, which is now $12,000 for single filers, $18,000 for head of household filers and $24,000 for joint filers.

For taxpayers that continue to itemize deductions, there have been some notable changes:

  • Pease limitation has been repealed, which means higher income clients will not have the value of their itemized deductions reduced or phased out.
  • Mortgage interest will be deductible up to $750,000 of debt. However, the interest on existing mortgages originating on or before December 15, 2017, will be deductible on debt up to $1 million. The effect of lowering the mortgage limit will likely be regional. Most mortgages are far less than $750,000. In addition, the deduction for interest paid on home equity loans, both new loans and existing, has been eliminated.
  • Charitable contributions will continue to be deductible. Donations of cash to public charities is deductible up to 60% of adjusted gross income, up from a limit of 50% last year – an important shift to note for wealthy clients who are charitably-minded.
  • Medical expenses will be deductible to the extent they exceed 7.5% of adjusted gross income, down from 10% previously. This change to a lower threshold is in effect for 2017 and 2018 only, therefore it may make sense to pay as much of these expenses as possible now, in order to take advantage of the change before the threshold reverts to 10% beginning with the 2019 tax year.
  • State and local income taxes (SALT), as well as sales and property taxes, are still deductible, but now capped at a total of $10,000 combined. This means a widely used year-end planning strategy of prepaying income and property before December 31 will benefit fewer people.

 With the standard deduction now so much higher, many taxpayers will not receive a tax benefit from charitable contributions, property taxes, mortgage payments and medical expenses. However, some clients may benefit from “bunching” these deductions, essentially doubling up on certain costs one year while taking the standard deduction another year. Also, donor-advised funds will likely become more popular, where the taxpayer gets a deduction by itemizing in the year a contribution is made to the fund and then directs distributions from the fund to charities in subsequent years.

3. Benefit from a larger child tax credit.

The child tax credit has doubled to $2,000 for each dependent under age 17. Additionally, more people will be able to take advantage of the higher tax credit because it does not phase out until income exceeds $400,000 for joint filers and $200,000 for single filers, up from $110,000 and $75,000, respectively, last year.

4. Assess alternative minimum tax (AMT) liability.

Fewer people will be subject to AMT this year. This is due to a combination of three key factors: more people will likely take the standard deduction; the AMT exemption has increased from $55,400 to $70,300 (single) and from $86,200 to $109,400 (joint); and the phaseout of those exemptions increased from $123,100 to $500,000 (single) and from $164,000 all the way to $1,000,000 (married). Although these changes will likely reduce AMT liability, the complexity involved in having to calculate tax liability twice, once under the regular tax code and again under the separate AMT rules, remains.

5. Reduce tax drag on investments.

A year-end review of clients’ portfolios may unveil certain tax inefficiencies. The taxes an investor pays annually on capital gains, dividends and interest could add significant drag to a portfolio’s long-term performance. Because many investors don’t consider the impact of taxes on their investment goals, focusing a spotlight on this issue can be an opportunity for you to add value.

Taxes on capital gains and qualified dividends remain unchanged under the new tax law. We still have four tax rates on long-term capital gains and qualified dividends depending on the taxpayer’s income bracket. The new tax act preserved the 0% tax on capital gains and qualified dividends for taxpayers whose taxable income is less than $77,200 for a married couple and $38,700 for an individual. With the standard deduction as high as it is, that would mean couples with gross income of less than $101,200 and individuals with gross income of less than $50,700 may be able to recognize investment gains while paying no tax on the gain – as long as those gains don’t push their income over the threshold.

The tax drag will be greater for portfolios that are actively managed and have a high turnover ratio. This could result in a lot of short-term capital gains being distributed to the investor each year. In the current tax environment, that means those short-term capital gains can be taxed at a rate as high as 37%. In addition, periodic rebalancing of a taxable portfolio to maintain proper asset allocation will cause further tax drag on investment returns.

Of course, you cannot eliminate all investment-related taxes, but you can help clients control them and improve a portfolio’s efficiency. To that end you may want to discuss these questions with clients:

  • Is the client invested in high-turnover mutual funds?
  • Did they receive a 1099 last year even though they didn’t sell the investment?
  • Did they pay taxes when rebalancing the asset allocation of their portfolio?
  • If the investments are for retirement, is the client paying taxes on income that will be used in the future, but isn’t being used now?

6. Check applicability of the Medicare surtax on investments.

Will clients’ investment returns be subject to the 3.8% Medicare surtax imposed under the Affordable Care Act (ACA)? The surtax still applies to income above $200,000 for single filers and $250,000 joint filers. Keep in mind the income level on which the Medicare surtax is assessed is not adjusted for inflation, meaning more clients are likely to become subject to this tax in the future, even if they aren’t currently.

Now is a good time to sit down with clients to review the impacts of tax law changes, assess strategies to reduce taxes and improve the tax efficiency of clients’ investment portfolios. With the right strategy in place to maximize deductions and minimize tax impacts, you can help to make the upcoming tax season as pain-free as possible for clients.

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BuckinghamBrandon Buckingham, JD, LLM, is vice president of advanced marketing at Prudential Financial Inc.