The Tax Cuts and Job Act of 2017 significantly impacts traditional year-end tax planning. Many people may remember that deductions that were available to individuals on their personal income tax returns are no longer allowed, or a ceiling has been set on the amount of deductibility.
Bunching deductions (other than state and local taxes) and the SALT cap
Beginning in 2018 the standard deduction has increased to $24,000 for married couples filing jointly, and $12,000 for single filers. However, many itemized deductions have been eliminated [such as casualty and theft losses (other than in a declared disaster zone) and miscellaneous itemized deductions] or limited [such as state and local taxes ("SALT") now capped at $10,000 per tax return, or $5,000 if married filing separately].
The deduction for charitable gifts has remained and has been increased to a maximum of 60% of adjusted gross income for cash contributions to public charities. However, many taxpayers may now find themselves below the standard deduction, even when taking into account their regular annual charitable contributions. One technique is to consider making a large gift to a donor advised fund. The contribution to the donor advised fund is considered to be the charitable contribution. You can then make smaller contributions from the fund to your intended charities in future years. The idea is to bunch multiple years of charitable contributions into one year so that you can exceed the newly increased standard deduction. Then, in subsequent years, you can still give to your favorite charities, but take advantage of the higher standard deduction because your itemized deductions will likely not exceed it.
For example, assume you have a capped SALT deduction of $10,000 and mortgage interest of $9,000. In the past, you typically made charitable contributions of $5,000. Under the new law you would receive no tax benefit from your $5,000 of charitable contributions (because your total itemized deductions would equal or be below your standard deduction). However, if you instead bundle your next four years of charitable gifts into this year by making a contribution of $20,000 to a donor advised fund, your total itemized deductions in 2017 would be $39,000, rather than $24,000 (the standard deduction). The next three years of itemized deductions would only be $19,000 but you would then be able to take the greater standard deduction of $24,000. This technique would generate an additional $15,000 of deductions over the four years.
529 Plans allow for tax-free growth (assuming the funds are used for qualified educational expenses) for contributions to the plan. Under the new tax law annual distributions of up to $10,000 can be made for kindergarten through high school tuition payments.
Consider gifting into a 529 plan for a child or grandchild before the end of the year. If you contribute more than $15,000 ($30,000 if you are married and gift-split) an election can be made to treat the gift as being made ratably over the next five years. This technique can be very helpful for estate tax purposes, especially if you live in a state with a state estate tax, such as Massachusetts. This means a married couple could transfer as much as $150,000 into a 529 account this year per beneficiary. The assets in the 529 plan can then grow tax-free, if used for qualified educational expenses.
IRA Contributions and Roth Conversions
Consider making a contribution to an IRA, even if the contribution is not tax deductible. Some contributions to an IRA are tax deductible, others are not. Whether a contribution is deductible depends on your income level and whether you (or your spouse) participate in a retirement plan.
For 2018 the phase out of Roth IRA contributions begins at $120,000 of income if single and $189,000 of income if married filing jointly. Once your income reaches $135,000 if single and $189,000 if married filing jointly, no contribution to either a traditional or Roth IRA is allowed. You can, however, contribute to a nondeductible IRA. For 2018 the amount that can be contributed to a tax-deductible IRA is $5,500, which can be increased by $1,000 to $6,500 for those 50 and older. This contribution can be made until April 15, 2019.
One benefit of contributing to an IRA is that you can convert (regardless of whether the IRA is deductible or nondeductible) to a Roth IRA regardless of your income. This may allow you to, in effect, contribute to a Roth IRA even if your income level prevents you from making a direct contribution to a Roth IRA. However, if you also have a traditional IRA for which you received a tax deduction you will be treated as converting a proportionate share of the traditional IRA, creating a tax liability even if the IRA you convert is a nondeductible IRA.
Roth IRAs allow for tax-free growth of investments versus a tax-deferred growth, meaning that in a Roth the distributions that are made in the future are not subject to income tax when you receive them. Distributions from a traditional IRA or 401(k) plan will be taxable to you when you receive them because you did not pay income tax on the money before the contribution. Beware, however, because when you convert to a Roth, you will need to pay all the income tax due on the amount you convert.