The Tax Cuts and Jobs Act of 2017, going into effect this year, casts a wide net of changes to current tax law, and with that comes planning opportunities.
Since by now you've probably already given up on those New Year's diet resolutions, let's see if there are some areas you can focus on to reinvigorate those financial resolutions to pay dividends for years to come.
Some Itemized Deductions Are Out
Most people will say they are deducting their tax preparation fees, but that's not correct. Even though self-preparation programs ask the question, it usually didn't get deducted due to the required threshold to trigger a deduction having to be greater than 2% of your adjusted gross income, or AGI.
In the new tax law, the miscellaneous itemized deductions have been eliminated. The elimination of this deduction will greatly affect occupational workers with unreimbursed employee expenses such as sales personnel, airline pilots, flight attendants, truckers, and retired taxpayers who are deducting investment management fees. The strategy for the latter is to pay your investment management fees for all your accounts from your non-retirement account, to push you above the 2% threshold.
Of course, there was an argument to be made about whether deducting IRA management fees by paying for them outside of the IRA itself was beneficial or not, and the answer was based on one's individual circumstances. But now, with the elimination of the deduction for investment management fees, that argument is a moot point; the deduction is no longer available. It's now time to shift out of autopilot and have a conversation with your adviser and custodian about whether you should have your IRAs start paying their own way again, because those dollars are essentially tax-free -- they've never been subject to taxation in the first place. And while you are at it, take the time to review all those autopilot phone app and magazine subscriptions you've been meaning to cancel as well.
Passthrough Income? Yes, Please
The new tax legislation created a passthrough income tax deduction of 20% on qualified business income, or QBI. A lot of guidance and regulation is yet to come on this new provision in the code, but there are some items we do know that you can take advantage of with a little previous planning. To sum it up quickly, a lot of the more complex provisions won't apply if your taxable income is less than $315,000 for taxpayers filing jointly, and this is where we'll be focusing. The words "taxable income" are important. That's not the usual adjusted gross income that you're used to hearing. The taxable income amount will come after your standard or itemized deductions are taken, essentially meaning that your total income could be a bit higher than the $315,0000 limit to take advantage of this deduction.
But how would a retiree or pre-retiree take advantage of this 20% deduction? Often, employees switch to consultative work as opposed to a traditional full retirement. This consulting income will most likely be eligible for the deduction if you are structured as a sole proprietor, partnership, or even as an S-Corporation. Regarding LLCs, they don't have their own tax structure and can choose which type of taxation they want. The default for a one-person LLC is to be taxed as a sole proprietor. So, let's look at an example to see how someone transitioning from retirement to part-time consultative work can really rack up some deductions.
Jane Smith recently retired but is now doing some part-time consulting for the company from which she retired, and a few other companies. Jane nets $50,000 from her consulting work, and her husband nets $100,000 from his employment. The first thing Jane does is set up a solo 401(k) for herself, since she still doesn't need the income. She sets aside $18,500 plus $6,000 (catch-up) as a deferral from income. Now she contributes a maximum profit share to herself of $9,294 (which for a self-employed person ends up being 20% after an adjustment for self-employment tax). Since those 401(k)/profit sharing deductions aren't business deductions, but rather deductions from her 1040 (unless future regulations are passed that stipulate otherwise), her passthrough qualified business income deduction would be another $10,000. The big picture equates to over $43,000 in deductions on $50,000 of income -- almost 88%. To take it a step further, let's say John defers the maximum $24,500 to his 401(k) plan. John and Jane are both 65 or older, so in addition to the new $24,000 standard deduction, they also get an additional $1,300 deduction each. Here's the high level:
Less John's 401(k)
Less Jane's 401(k)
Less Jane's Profit Share
Less Jane's Passthrough Deduction
Less Standard Deduction
Less Elderly Deduction
Income Subject to Tax
In that example, they brought $150,000 of income down to $55,106 -- a 63% reduction. But now you may be asking, what if I don't have this consulting opportunity? Are there strategies for me to reduce my taxes with this new law? Well the good news is that REIT dividends, and most likely income from rental properties on Schedule E, will be eligible for the 20% passthrough deduction as well. I say, "most likely," because the income from the directly-held rental property could be ruled ineligible in future regulations, but most tax professionals are interpreting it to be included at this point in time.
This now gives you two more homework items: 1) Increase the rents on your property that you've been meaning to do for years now, and 2) spend a little time on asset location for your portfolio by making sure you have tax efficient assets such as REITs and stocks that receive preferential treatment in your brokerage account, and tax-inefficient assets that produce ordinary income in your retirement accounts.
Maximizing Roth IRAs
Things are often better when Congress doesn't act, and in this case, IRAs were mostly left alone. While Congress did eliminate IRA recharacterizations, easier explained as a "do-over," they left the known backdoor Roth strategy unscathed. When your adjusted income is too high (starting at $189,000 in 2018 for joint filers), you become limited on your ability to make Roth IRA contributions.
The current strategy is to contribute to a regular IRA without taking the deduction, and then eventually converting that IRA to a Roth with zero to minimal taxes. When doing this, make sure to let your tax preparer know, as form 8606 will be required for the non-deductible IRA contribution. I've seen a popular retail tax preparation software in the past not handle this situation correctly.
The catch is if you currently have any IRAs in your name, you can't cherry pick a specific IRA for this strategy. And this includes SEP and SIMPLE IRA plans as well. The fix? An IRA is exactly what the acronym stands for: Individual Retirement Account. Going back to John and Jane, if their income is above the threshold, but Jane rolled over her old employer's 401(k) plan to an IRA, this would not be a good strategy for her. But that doesn't mean that John couldn't take advantage if he didn't own any IRAs since the presence of Jane's IRA, even on a joint return, won't affect the strategy for him. There's still a ray of hope for Jane though. Depending on the custodian of her 401(k), she could do a reverse rollover, where she transfers her IRAs to her 401k, leaving her with zero IRA assets. Now that she's cleaned her hands of traditional IRA monies, she could investigate implementing the backdoor Roth strategy, allowing them to shelter an additional $6,500 each in Roth IRAs.
The good news for John and Jane is that in my original example their income isn't above the Roth contribution limits. It's now down to $55,106, which, due to their proper planning affords them about $22,000 they can trigger in long-term capital gains at a zero percent tax rate. Now they can take $13,000 of those proceeds (or $26,000 if they didn't contribute last year) and shift those from their brokerage account to fund their Roth IRAs. Since they've just sheltered more assets from future taxation, they can celebrate with a glass of champagne, or get back to that original resolution of going to the gym.
About the author: Joe Clemens, CFP, EA, is a founding partner of Wisdom Wealth Strategies and has taught tax and financial planning as an instructor for the College for Financial Planning. His practice revolves around helping clients turn the complexities of tax and finance into simple and actionable steps to reach their goals. Wisdom Wealth Strategies, LLC is a registered investment adviser offering advisory services in the states of Colorado and California, and in other jurisdictions where exempted. Clemens is also a member of the FPA of Colorado.
This article was written by a staff member of TheStreet.