The 2019 tax filing season will be very different from recent ones for many taxpayers, and not just because of the 2017 tax cut legislation. The law cut marginal tax rates and added some tax credits, but it also eliminated some deductions.
1. Fallout From Tax Law
As a result of the 2017 tax legislation which, among other changes, doubled the standard deduction but eliminated the personal exemption and capped the deduction for state and local property taxes, many filers will no longer itemize deductions. They will instead take the standard deduction, but still be able to use so-called “above the line” deductions available to all taxpayers, including those who don’t itemize.
In the end, some will end up paying more in federal taxes. The savings due to the cut in their marginal tax rate and doubling of the standard deduction will equal less than the savings they enjoyed previously from itemizing, taking the full deduction for state and local property taxes and personal tax exemptions.
The percentage of taxpayers who itemize is expected to decline from about 27% to 10%, according to the Tax Policy Center.
2. Smaller Refunds
Many taxpayers who historically receive refunds will collect less this year. They won’t necessarily be paying more in taxes — most taxpayers will be paying lower marginal tax rates this filing season — but the amount of taxes withheld from paychecks wasn’t adjusted enough to reflect the new tax regime. The Government Accountability Office estimated last July that 21% of taxpayers will have had too little withheld from their paychecks for taxes, up from 18% the previous year.
One of the reasons for the under-withholding: The new tax law eliminated personal exemptions, which prior to the new tax law served as the basis for determining one’s withholding amount. Employees would indicate on their W-4 the number of exemptions they would claim, and employers would adjust employees’ pay accordingly. For this tax season, employees would have had to consult the IRS’ Withholding Calculator to update their withholding schedule with their employers.
According to data from the IRS based on the first three weeks of the current tax season, the average refund has fallen from $3,169 this time last year to $2,640.
3. Capital Gains Distributions
Another surprise for taxpayers this season: Taxes owed on capital gains distributions from funds, including funds that lost money in 2018. Only taxable accounts are affected.
According to Russell Investments’ analysis of Morningstar data, 86% of U.S. equity funds — including mutual funds and ETFs — distributed capital gains in 2018, up from 65% in 2017, and the average distribution equaled 11% of the money invested.
“Think about that,” writes Frank Pape, director of consulting services at Russell Investments, in a recent blog post. “Equity markets were down -5% for the year and taxable investors will be receiving an average distribution of 11% on the value of their investments. And this 11% distribution amount is the highest number we’ve seen since we’ve been tracking back to 2001.”
A total 224 U.S. index funds distributed gains greater than 5%, including 101 with taxable distributions topping 10%, said Pape, referring to Morningstar data. “That goes against conventional wisdom.”
Even some ETFs, touted for their tax efficiency, distributed capital gains last year. Most of those gains were in the mid- to low single digits, but a few were in the double digits, including WisdomTree CBOE Russell 2000 PutWrite Strategy Fund (RPUT) and SPDR NYSE Technology ETF (XNTK), according to Morningstar.
“Some people will be really surprised by their 1099s,” said Pape. “That makes for challenging conversations with financial advisors.”
Despite these negative surprises and positive changes in the tax code that will cut marginal tax rates for most taxpayers — too many to recount here — taxpayers still have time to reduce their tax bills this filing season, taking advantage of above-the-line deductions before April 15.
Reducing Taxes With Above-the-Line Deductions
Contribute to an IRA. Taxpayers who don’t have a retirement plan at work can contribute a fully deductible $5,500 per person, or $6,500 if they’re 50 or older, with a modified adjusted gross income up to $63,000 if single or up to $101,000 if married and filing jointly. The deduction begins to phase out above those levels and is eliminated for MAGIs above $73,000 for single filers and above $121,000 for married, filing jointly.
Convert nondeductible IRA contributions to a Roth IRA. Now is a “perfect time to fund a backdoor Roth with nondeductible IRA contributions,” says Megan Gorman, the founding partner of Chequers Financial Management, based in San Francisco. “As soon as you fund an IRA for 2018 and 2019, you can immediately convert it to a Roth IRA, but you have to be very careful.”
There could be adverse tax consequences for taxpayers who fund a backdoor Roth IRA if they have other IRAs, explains Gorman, who recommends that those taxpayers consult a tax professional beforehand because the IRS rules are complicated.
Fund a health savings account, if you can. The account, which must be linked to a high-deductible health plan, is more attractive than an IRA because distributions are not taxable if they’re used to fund qualified medical expenses. This option is only available for taxpayers under age 65.
Deduct student loan interest payments. Taxpayers can deduct up to $2,500 in student loan interest payments for 2018 up to certain income limits — a modified AGI of $65,000 for single filers and $130,000 for married filing jointly. The deduction phases out between those levels and $80,000 for single filers and $165,000 for those married and filing jointly.
American Opportunity Tax Credit. Parents of college students can claim this credit, worth up to $2,500 for students during their first four years of college who enrolled at least half time and have not been convicted of a felony drug offense. The credit is available for single taxpayers whose modified adjusted gross income is $80,000 or less ($160,000 or less for joint filers) and phases out at MAGIs above $90,000 ($180,000 for joint filers).
Lifetime Learning Credit. Parents of college students can alternatively claim this credit instead of the American Opportunity Tax Credit — they can’t claim both education credits — but it’s worth only $2,000 and phases out at a lower threshold, above $67,000 for single filers and $134,000 for joint filers. The credit, however, is not limited to the first four years of an education, and the student doesn’t have to be enrolled at least half time or be pursuing a degree or other recognized academic credential. In addition, a felony drug conviction is not a disqualification.
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