Tax Reform 2018 Explained — Understanding the Changes

If you’re like me, you’re sitting down on weekend mornings amongst piles of receipts, tax forms, and medical billing records trying to make sense of just how tax reform will impact my tax return this year. Why? Because it’s tax time and so far, tax reform in 2018 is doing a doozy to my regular tax preparation.

In years past, I always managed my tax withholding aggressively with a target of receiving either a negligible tax refund or owing little to the greedy Feds. I don’t want to give Uncle Sam an interest free loan nor do I wish to pay any underpayment penalties on the taxes I owe.

This year’s tax return preparation is different, however. I didn’t know how my tax situation would change under the new tax laws which came into force in 2018. Not sure of how I should adjust my withholding levels, I left my W-4 filing situation and withholding allowances alone.

After exploring the best tax software options and finally settling on TurboTax, I’ve come to my conclusion: roughly $1,500 owed in Federal income tax and a state tax refund of approximately $500. In net, my rational decision not to rock the boat cost me $1,000 more than I withheld this tax filing season.

Sorting through every income, deduction, and tax credit tab in my tax software, I wanted to make sure I’d done everything correctly. After some consternation, it appeared all was in order.

Now, I’m planning how best to prepare for my tax return next year to redeploy my strategy of $0 refunded or paid. I’m reading articles in search of useful tax tips.

If you share a similar goal or want to learn about how some major changes in the tax code could affect your taxable income going forward, this post is for you.

What is the 2018 Tax Reform and What Did it Accomplish?

When Congress debated changing the tax code in 2017, the intended spirit was to simplify the tax planning process for the individual tax payer. The primary instrument for enacting this change was the increase in the standard deduction.

However, the tax code also discontinued or altered a number of common tax deductions and tax credits, changed the economics behind home ownership in some parts of the country, eliminated personal exemptions, and shifted tax brackets and rates, among other things.

The tax reform bill also included major changes for corporate taxes. The new tax rules benefited businesses immensely by receiving a significant drop in the federal corporate tax rate. The 2017 corporate tax rate stood at 35% but dropped to 21% in 2018 onward.

For individuals, the tax reform law made itemizing deductions harder and pushed many more instead to use a larger standard deduction. In theory, the standard deduction under the new tax plan would make far fewer individuals qualify for itemizing deductions and make tax planning simpler.

For reference, to itemize your deductions, you must exceed the standard deduction. Therefore, if you raise the standard deduction bar, fewer will qualify to itemize.

Tax reform was a two-sided coin, however. While it projects to have the U.S. population pay less over the life of the tax changes, there are winners and losers.

Let’s walk through some of the major changes tax reform has brought and see who’s likely impacted most.

Related: Form W-2, What You Need to Know 1099 vs. W-2: Contractor and Employee Taxes, Costs and Benefits

How did Tax Reform Change the 529 College Savings Plan?

A 529 college savings plan is a tax-advantaged savings account specifically designed to encourage saving funds for qualified future higher-education costs. These qualified expenses include tuition, fees and room and board. Money in these accounts invest and grow tax free if used for qualified educational expenses.

Old Rule:

529 college savings plan funds could only be used on qualified higher education expenses.

New Rule (effective Jan. 1, 2018):

Count another victory for wealthy families who can now use funds from 529 savings plans for private K-12 schooling for their children. The tax benefits from this account now extends to eligible education expenses for all elementary or secondary public, private, or religious schools.

The new rule allows the plan holder to withdraw a maximum of $10,000 per year per student for education costs. Given the added flexibility of these educational plans, you might consider employing any unused funds in a manner which allows you to invest in yourself.

Related: How to Save Money and Live Within Your Means

How did Tax Reform Change the ACA (Obamacare) Individual Mandate?

The Affordable Care Act (ACA), more commonly referred to as Obamacare, passed Congress in 2009. The law offered access to a national health insurance exchange, standardized levels of insurance benefits, tax credits to subsidize health insurance for certain income thresholds, among many other changes to the existing healthcare system.

Old Rule:

In its original form, the ACA required every individual to carry health insurance coverage. Those who chose not to carry coverage and did not qualify for an exemption faced a range of tax penalties, depending on income.

New Rule (effective Jan. 1, 2019):

As of Jan. 1, 2019, there is no more individual mandate. As such, there are no more penalties for not purchasing health insurance. The argument behind this removal is it will decrease spending on tax subsidies offered by the law (if you aren’t required to have health insurance, the government isn’t required to pay tax credits to people who don’t carry it) and balance the rise in premiums seen for ACA enrollees.

However, absent a mandate to carry health insurance, many industry watchers caution young invincibles on high deductible health plans won’t sign up for health coverage. As a result of these individuals being less likely to carry insurance, these experts foresee likely premium increases for those who carry insurance coverage from the ACA marketplace.

If these premium increases occur, some insurers could leave the marketplace altogether. This drop of the insurance mandate is a formidable blow to the primary thrust of the Affordable Care Act.

Related: What is an HSA? The Ultimate Tax Shelter to Save Money This is the Millennial Retirement We Deserve

How did 2018 Tax Reform Affect Alimony?

Alimony is the payment made from one ex-spouse to another in support of their living expenses. Tax reform reversed who could take a tax deduction on these payments.

Old Rule:

The person paying alimony could deduct the payments from their income while the person receiving must include them in their taxable income.

New Rule (effective Jan. 1, 2019):

No longer does the person making the payments get to deduct them from his or her income. Now, the recipient does not claim them as taxable income. Any divorce proceedings or separation agreements which were signed or modified before January 1, 2019 were not affected. This rule change becomes effective in 2019.

As you can imagine, if divorce proceedings weren’t contentious enough, many likely attempted to fast track (or delay) to take advantage of this change.

What did Tax Reform Change about the Child Tax Credit?

The child tax credit was designed to offset costs associated with raising children each year. The attractive nature of the credit came in the form of a dollar-for-dollar credit against your tax liability as opposed to a deduction which reduces your taxable income.

Old Rule:

The child tax credit was available for each child under the age of 17 for $1,000. The tax credit is reduced by $50 for each $1,000 the taxpayer earns over certain thresholds. The tax credit is also subject to phase-outs starting at a modified adjusted gross income (AGI) over $75,000 for single taxpayers and heads of household, $110,000 for married couples filing jointly and $55,000 for married couples filing separately.

New Rule (effective Jan. 1, 2018):

Effectively, the child tax credit doubled per child up to $2,000 under tax reform in 2018. Up to $1,400 of the child tax credit received is a refundable tax credit (offsets the balance of your tax liability and any excess comes to you via a tax refund).

The new rule also includes a $500 nonrefundable tax credit per dependent other than a qualifying child. Phaseouts also apply to the new child tax credit.

For AGI greater than $200,000 (single taxpayers) and $400,000 for married couples, filing jointly, the phaseout reduces the child tax credit.

Related: How the Earned Income Tax Credit Could Get You More Money

Tax Reform Resulted in Lowered Individual Income Tax Rates

America employs a progressive tax system for income taxes. This means as a taxpayer makes more income and exceeds certain levels, the amount of tax paid on an additional dollar of income increases.

For example, if you ignore the effects of the standard deduction and you made $35,000 as a single filer in 2018, you would pay 10% on the first $9,525 ($952.50) and 12% on the remaining $25,475 ($35,000 — $9,525) or $3,057. You would not pay 12% on the entire $35,000.

The new tax law changed two things about the 2018 income tax brackets and rates in 2018:

1. Lower tax rates: The tax law kept the seven existing federal income tax brackets. However, it lowered the tax rate of every bracket except for two. This reduces the amount of money you pay on each additional dollar of income by varying amounts.
2. Different taxable income ranges: The law also changed the 2018 income tax brackets for filers. Meaning, the income ranges applicable to each tax rate either widened or narrowed, depending on the level of income.

On the low end, the bottom two brackets remained unchanged, while on the upper end, the highest tax rate (37%) doesn’t begin until a single taxpayer has earned $500,001 of taxable income as opposed to $426,701 under the old tax brackets.

Related: How to Make a Lot of Money and Fail Financially

How did 2018 Tax Reform Change the Standard Deduction?

Tax reform changed the nature of filing your tax return by increasing the standard deduction and making most taxpayers ineligible for itemizing their tax deductions. As a result, a lot fewer people qualify for taking the most common tax deductions.

Old Rule:

Depending on filing status, standard deduction amounts were almost half of what they are under the new tax rules. In 2017, the standard deduction for single filers was $6,350 and $12,700 for married filing jointly tax payers.

New Rule (effective Jan. 1, 2018):

Because tax reform wanted to simplify the tax planning process, the IRS now has almost doubled the standard deduction for all filing statuses.

For single filers, the standard deduction stood at $12,000 in 2018. Married, filing jointly filers saw their standard deduction go to $24,000. In 2019, the amounts will be $12,200 and $24,400, respectively.

Further, the elderly or blind receive an additional standard deduction worth $1,600 in 2018 vs $1,550 in 2017.

These changes make most people claim the standard deduction on their tax forms because it not only simplifies their return, it is also harder to itemize.

Related: 10 Simple Steps for Creating a Budget in Excel How to Stick Rigidly to a Personal Budget

What Happened to Personal Exemptions?

A casualty of 2018’s tax reform was the personal exemption. Previously, each person on the tax return (filers and those being claimed) received an exemption to lower the taxable income on the return.

For example, if you were a family of four, you received four exemptions worth $4,050 per family member in 2017. Now, you don’t have the ability to claim personal exemptions on your tax return.

The argument here was the higher standard deduction would cover this loss. Originally, many feared larger families would stand to lose from this change. However, the enhanced child tax credit from above minimized this loss.

Old Rule:

Tax filers can reduce their adjusted gross income by claiming personal exemptions, $4,050 per person claimed in 2017. These amounts phased out for taxpayers earning above certain thresholds. The phase out began at 313,800 for married, filing jointly couples, $287,650 for heads of household, $156,900 for married, filing separately, and $261,500 for all other taxpayers.

New Rule (effective Jan. 1, 2018):

There are no more personal exemptions allowed through 2025. If no legislation is passed making the individual tax payer changes permanent, personal exemptions will reappear starting in 2025.

Related: Don’t Miss These 10 Last-Minute Tax Savings Opportunities

What did the 2018 Tax Reform Change Taxes for Homeowners?

Tax reform implemented multiple changes for homeowners, none for the better. Primarily, it changed the treatment of deductions many claim related to homeownership, the hurdle to surpass for itemizing (higher standard deduction), and the criteria to qualify for excluding gains made on home sales.

Old Rule (Mortgage Interest Deduction):

The higher standard deduction created not only a higher hurdle to qualify for the mortgage interest deduction, but tax reform also lowered the levels of mortgage principal and associated interest expense which qualifies for deductibility.

In the past, you could deduct the mortgage interest associated with the first $1 million of your mortgage and the interest associated with the first $100,000 of a home equity loan (assuming the funds are used for qualifying home improvements).

New Rule (effective Jan. 1, 2018)

Tax reform changed this only to allow the interest expense associated with the first $750,000 for taxpayers who are married and file jointly, and $375,000 for single taxpayers. If you originated a mortgage in 2018 above this threshold, it gives you the incentive to pay off your mortgage faster.

It is worth noting this limit only applies to new loans originated after December 15, 2017. Preexisting mortgages are grandfathered under the old limits.

And home equity loan interest also is still deductible if the loan is used to “buy, build or substantially improve” the home which secures the loan.

The IRS provided an example to illustrate these rules to simplify the understanding. If a taxpayer took out a $500,000 mortgage to buy a home valued at $800,000 and subsequently took out a home equity loan for $250,000 to build an addition on the home, the interest associated with both the mortgage and the home equity loan are deductible. This is because the two loans, in aggregate, combine for the maximum of $750,000.

If the taxpayer uses the home equity line of credit (HELOC) for personal expenses other than qualified home expenses, that interest from the loan is not deductible.

Given the higher watermarks of these amounts, higher-income individuals located in non-coastal areas and those in high cost of living areas are disproportionately impacted.

If you own an investment property, you can still claim MACRS depreciation expense as a deduction to offset income earned on your Section 1231 property. This is still a powerful way to move toward financial independence as these changes to personal homeownership do not also extend to real estate investing.

Old Rule (higher standard deduction hurdle):

As stated previously, the standard deduction increase made it harder to qualify for itemizing deductions. Many expenses will be insufficient to itemize and forces the homeowner into the standard deduction because it provides better tax relief.

New Rule:

Many individuals will not be able to claim these tax deductions against their federal adjusted gross income. In some cases, they may still apply against state income tax adjusted gross income.

Old Rule (excluding gains made on home sales):

Previously, homeowners could exclude up to $250,000 or $500,000 in gains realized on their primary residence when selling for single and married, filing jointly tax filers, respectively.

The requirement to qualify was the homeowner must have owned and lived in the residence for at least two of the five years prior to the sale. The exclusion can only be claimed once in a two-year period.

New Rule (effective Jan. 1, 2018):

Homeowners may still exclude gains up to $250,000 or $500,000 when they sell their primary residence, however, the duration of their stay is longer to qualify. Now, when people sell their homes after Dec. 31, 2017, they must have used the home as their primary residence for five of the previous eight years to claim the exclusion. This exclusion can only be claimed once in a five-year period.

This change will impact my intention to sell my condo this year. Previously, I had lived in the unit for two and a half years and rented it out the past two. However, under these new rules, I will pay long-term capital gains taxes on my home price appreciation. Clearly, this is unwelcome news.

Simply put, 2018’s tax reform has made it less-advantageous to be a homeowner from a tax point of view.

Related: Should I Pay Off My Mortgage Early? How to Pay Zero Tax on Passive Income

The Contentious State and Local Taxes Cap

Some of the above changes benefited most in America (save homeowners). A higher standard deduction, lower tax rates and bigger brackets helped many pay less in taxes in 2018.

However, not everyone was as lucky. Many who lived in high cost-of-living areas paid a considerable amount of money each year in state and local taxes (SALT taxes) and a new cap impacted them considerably.

Old Rule:

No limit on amount of state and local property, income, and sales taxes as itemized deductions.

New Rule (effective Jan. 1, 2018):

In 2018, there was a $10,000 cap placed on the amount of SALT taxes which can be deducted from your federal taxable income. Homeowners living in these higher cost areas were hardest hit because many deducted real estate and property taxes as well as other applicable state and local income taxes.

This new cap limited their ability to do so. The only way high cost of living homeowners can come out ahead is if their incomes fell into lower brackets, which would have more of their incomes fall into lower rates.

By placing a $10,000 cap on SALT taxes, the argument to be made for economic efficiency. Not every American takes the SALT tax deduction. High-income filers are much more likely to itemize and therefore more likely to claim the SALT deduction on their returns.

Further, the higher your income, the more valuable tax deductions become because that income is being reduced from your top marginal tax bracket.

In the past, the SALT tax deduction effectively subsidized high earners in high-cost of living areas, namely on the coasts. Those with high incomes logically claimed higher SALT deductions for things like property tax, real estate, and state and local income taxes.

However, for very high earners, limiting these deductions could be made up for with lower federal income tax rates. Whether you view this in a favorable light likely stems from how you will be impacted.

If you earn above $100,000 but you’re not close to $500,000, you likely come out behind. This is because you don’t earn enough income to benefit from lower income tax rates to offset the impact from capping the SALT tax deduction.

From a purely economic perspective, the cap reduces cross-subsidization and relies more on cost-causation principles to have citizens bear more cost of the policy choices made by their state. This lessens the subsidization made by lower tax states to higher tax states.

Related: Why Shrinking Inflation Could Be the Best Christmas Gift Are the 2019 Retirement Plan Limits Important?

How did Tax Reform in 2018 Affect Student Loan Interest Paid by Your Parents?

While not a new deduction, the ability to claim a tax deduction for student loans did become easier after tax reform. In years past, when parents paid money toward a child’s student loans, no one could claim a tax deduction. The money paid toward the loans was lost in space from a tax perspective.

Old Rule:

The borrower couldn’t claim to have made a payment and therefore couldn’t claim a tax deduction against their taxable income for the student loan interest paid. And the parent(s) couldn’t claim a tax deduction either because they weren’t liable for the student loans in the first place.

New Rule:

Under 2018 tax reform, the new rules changed this scenario. Originally, the IRS mandated you must pay for your own loan and be liable for it in order to qualify.

Now, your parents can pay off student loans and you get a tax deduction for it. If you’re the student loan borrower, you just got double the benefits: money toward the loans AND a tax deduction.

The finer details behind the change are that the IRS now treats money gifted to you by your parents to pay for the student loans as though they gave you money and you then used it to pay the debt. In essence, a child who isn’t claimed as a dependent can qualify for tax deductions worth up to $2,500 per year for student loan interest paid by Mom and Dad.

However, it still makes sense to refinance student loans to lower the interest expense if it works for your situation.

Related: In Defense of the Public Service Loan Forgiveness Program 10 Tips to Qualify for Public Service Loan Forgiveness

How has the Threshold for Medical Expenses Changed under Tax Reform in 2018?

For the 2018 tax year, taxpayers can deduct medical expenses which exceeded 7.5 percent of their adjusted gross income. In other words, if you had $100,000 of adjusted gross income in 2018 and qualifying medical expenses of $10,000, you can deduct $2,500 from your taxable income (AGI).

To illustrate:

Adjusted Gross Income Threshold: $100,000 * 7.5% = $7,500

Deductible Medical Expenses: $10,000 — $7,500 = $2,500 available medical expense deduction

Taxable Income: $100,000 — $2,500 = $97,500

The IRS allows medical expense deductions for qualified, out-of-pocket medical costs. Additionally, you can deduct mileage or other travel expenses associated with medical visits.

If you paid for expensive medical treatment which counts as a qualified medical procedure, assisted living or other long-term care services, they may tally above the required threshold.

As a note, in the 2019 tax year, this 7.5% AGI threshold increases to 10%.

Some Other Items of Note

Under tax reform, many changes occurred, as you can read above. Some items which did not change include whether life insurance proceeds are taxable (they’re still not in most circumstances) nor how to calculate imputed income on life insurance (still helping to make term life insurance worth it).

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Originally published at youngandtheinvested.com on February 27, 2019.