The House and Senate conference committee worked out differences in their respective tax bills last week. The final bill was released Friday evening and a preliminary read indicates the compromised bill is an improvement from either individual bill.
The tax-reform bill is still far from perfect, but it is a marked improvement over the current system, especially with respect to corporate taxation.
Our last two pieces on the tax-reform bill were focused on two provisions that we thought needed to be killed—the FIFO capital gains provision and the alternative minimum tax (AMT). The conference committee killed the FIFO provision, but left the alternative minimum tax for individuals. The exemption amount for the AMT was raised which helps, but it is still a major disappointment that Republicans weren’t able to eliminate it all together.
One of the most disappointing aspects of the bill is that the provisions for individuals are temporary. To meet Senate budget rules, many of the individual tax changes expire after 2025. That means that unless the Republicans can maintain control of the House, Senate, and White-House in the 2024 elections, you should think of any tax reductions as temporary—especially if you are a high-income earner.
Individual Tax Rates
Like much of the bill, the Conference Committee stuck closer to the Senate’s version of the bill than the House’s version. There will be seven brackets for individuals in 2018 with a low rate of 10% and a high rate of 37% that kicks in at income of more than $600,000. Below is a comparison of the individual tax rate tables for single and joint filers under the current tax code and the proposed tax code.
|10% >||$0||$0||10% >||$0||$0|
|15% >||$9,525||$19,050||12% >||$9,525||$19,050|
|25% >||$38,700||$77,400||22% >||$38,700||$77,400|
|28% >||$93,700||$156,150||24% >||$82,500||$165,000|
|33% >||$195,450||$237,950||32% >||$157,500||$315,000|
|35% >||$424,950||$424,950||35% >||$200,000||$400,000|
|39.6% >||$426,700||$480,050||37% >||$500,000||$600,000|
The big simplification for individuals is the doubling of the standard deduction. For a married couple filing jointly, the standard deduction is now $24,000. The higher standard deduction, along with a child-tax credit of $2,000 that starts to phase out at $400,000 instead of $110,000 in income will allow many more individuals to file their taxes using the standard deduction as opposed to itemizing.
State & Local Tax and Mortgage Interest Deductions
For those who itemize, the biggest deductions are often for state and local taxes, mortgage interest, and charitable donations. The charitable deduction is maintained. The much maligned limit on state and local tax deductions was revised in conference so that individuals can deduct up to $10,000 of state and local property, income, or sales tax.
The Mortgage interest deduction was also revised in conference. Individuals can now deduct up to $750,000 in mortgage interest including both primary and second homes acquired after December 15, 2017. The limit on mortgage interest remains $1,000,000 if incurred before that date. The deduction for home equity interest was still eliminated starting in 2018. Importantly, the rule also allows individuals to refinance mortgage debt of more than $750,000 incurred before December 15, 2017 without losing the interest deduction as long as the principal balance does not increase.
Alternative Minimum Tax (AMT)
The individual AMT was improved but not eliminated. The exemption amount was increased to $109,400 for married couples who file jointly and the phaseout threshold was boosted to $1,000,000. This should lower the number of tax-payers subject to the AMT.
Capital Gains and Dividends
Capital Gains and Dividend rates are essentially the same under the tax reform bill. For married couples filing jointly, if your income including dividends and capital gains is above $77,200 but below $479,000 you pay a 15% capital gains rate. Above $479,000, the capital gains rate is 20%. If you make over $250,000 as a married person filing jointly, your capital gains and dividend tax increases by an extra 3.8% which was added when Obamacare was passed.
One of the other big disappointments in the bill was the change Congress made in the way almost everything in the code is indexed for inflation. Instead of using the traditional Consumer Price Index (CPI), the IRS will make inflation adjustments using the Chained-CPI. The Chained-CPI has increased at a slower rate than the traditional CPI. The change will slowly and quietly result in higher taxes than would otherwise be the case under the traditional CPI. The primary difference between the chained CPI and the traditional CPI is how substitutions are accounted for. Under the traditional CPI, if the price of steak increases, it is assumed consumers still want to buy steak. The chained-CPI says that if the price of steak increases consumers will buy less steak and more chicken, so the weights of steak and chicken in the chained-CPI are changed. When the price of steak increases it is true that consumers buy more chicken, but one could argue by substituting chicken for steak, one’s standard of living is not being maintained.
529 Plans & Coverdell Savings Plans
One of the more interesting changes in the tax-reform bill was made to 529 plans. The tax bill expands the use of 529 savings plans to elementary, secondary, and home-schools. A maximum of $10,000 per beneficiary per year can be used to pay for qualifying expenses for elementary and secondary school. 529s are funded with after-tax money, but income and gains are not taxable, and distributions are tax-free when used for qualifying education expenses. The expansion of the 529 to elementary and secondary schools is likely to make the Coverdell savings account obsolete.
The Estate tax exemption will be doubled to $11 million starting in 2018 and will be adjusted for inflation annually. The increased exemption expires starting in January of 2026. Married couples will be able to pass on estates worth up to $22 million without paying estate tax. Unfortunately, the change was not made permanent and a higher estate tax exemption isn’t something Democrats have historically favored.
Obamacare Penalty Repealed
The repeal of the Obamacare penalty survived the conference committee and will change to $0 starting in 2019.
Business tax reform was of course the central plank of the tax-reform efforts. We won’t get into the details of the business tax changes in this post other than to say that they are the best part of the bill. A lower corporate tax rate is bullish for the stock market and bullish for the economy. That is also true for the lower tax rates on pass-through businesses.