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  • Jeff Burke

A Huge Change To Your Taxes, Maybe

 

As an advisor, I have to consider myself politically agnostic. Like everyone else, I have my personal beliefs, but, as an advisor, my job is to understand the current set of rules and laws in order to help my clients navigate those rules today and prepare for how those rules may impact them in the future given their projected financial future. I think it is a fool’s errand to try and predict who will elections and what policies will result from the outcome especially given the state of our lawmaking bodies. With all of that being said, I have no idea who will win the race for President or what party will end up with control of the House or Senate after the elections this fall. Whatever the outcome of those races is sure to trigger new legislation and I will deal with that when it comes. The headline here is not meant as a predictor of what may happen in November but is based on a current law on the books that is set to change in the near future. That is what I want to discuss today.


In 2016, the Tax Cuts and Job Act (TCJA) was passed which not only lowered tax rates but also expanded the tax brackets meaning that the old 25% rate became 22% and that bracket was expanded to include higher taxable income than the old 25% bracket did. As a result, many people enjoyed lower taxes and this created both new opportunities and challenges from a financial planning perspective.


But here’s the thing. That law was never intended to be permanent.  Many people may not realize this, but the law was written to sunset after 2025 meaning as of now, we will revert to the previous tax laws starting in 2026.  The immediate reaction many have is to be concerned that they will suddenly be stuck paying much more in taxes in 2026 than they have been paying in recent years. Here you can see a side by side comparison of what the current tax rates/brackets are compared to the projected brackets in today's dollars. The good news is that the brackets will almost surely be adjusted upward based on inflation from their 2016 levels.


Here you can see there isn’t much change in the lower brackets except for 12% becoming 15% The biggest impact is to the 24% bracket which becomes 28% and transitions to the 33% $100,000 faster than the transition to the current 32% bracket. For a family with a taxable income of $300,000 this will result in an extra $10,000 of federal income taxes owed, ouch. For a family with a taxable income of $400,000 this results in an extra $18,000 of extra federal income taxes. Yikes.


It may not be as dire as it looks

Paying an extra $10,000+ in taxes sure sounds bad, but we need to take a closer look at the law. It isn’t just the tax rates and tax brackets that will change. If you recall, this law also brought massive changes to the standard deduction, personal exemptions and deductible expenses. All of those would revert back to their previous status as well.



With TCJA the combination of eliminating deductible expenses and increasing the standard deduction meant that the vast majority of people started taking the standard deduction. If we revert to pre-TCJA, a family will be able to claim $25,850 between the standard deduction and exemptions which is $3400 less than you can take today. But the option to claim more in deductions than you can today, and by a significant amount for many people, comes into play. Let’s look at a few common examples.


1. Mortgage interest – This is the largest deductible expense for many people. We have had a long run of really low interest rates until the last year. As a result, many people are sitting with sub 4% mortgages right now so the value of this could be somewhat muted. For instance, a $400,000 mortgage at 4% would generate $16,000 of interest. Under the TCJA rules you would still need to find another $13,200 in itemized deductions to get above the standard deduction. But once we revert to the old rules this one deduction alone would put a family over the standard deduction threshold and open the door to claim all of the other additional itemized deductions. For anyone who has purchased a house recently and has an interest rate of 6% or higher, this could be a major break.


2.  State & Local taxes (SALT) – This was a major point of contention in the bill as it was a blow to states with higher tax rates. Pre-TJCA you could claim an itemized deduction for the full amount of these taxes but that was limited to a $10,000 cap with TCJA. What all falls under the SALT umbrella? State income taxes, real estate taxes and personal property taxes. In Minnesota, where I live, an income of $300,000 comes with close to a $20,000 state income tax bill alone plus whatever your real estate taxes are which can easily be several thousands of dollars.


3.  Additional deductions – While these may not apply to as many people or be as high in dollars, once you cross the threshold to itemize deductions you open the door to a host of other smaller deductions that can also reduce your taxable income. Items such as charitable donations, medical expenses, investment expenses including advisor fees all come back into play.


4.  To be fair other things would go away that could hurt and increase your potential tax burden.

  • The QBI deduction for those that are small business owners would go away

  • The exemption amount for Alternative Minimum Tax (AMT) will be lowered which is of particular risk to those with certain types of equity comp

  • The child tax credit gets phased out at lower incomes

  • The amount excluded for estate taxes will be cut in half. This won't impact your income taxes but is a major issue for those with higher net worths.  


Will you pay more or less in taxes?

This will depend entirely on your level of income and what deductions you are able to claim. I went back and looked at one of my pre-TCJA returns, 2015, to see how I was taxed then versus how I would be taxed in 2024 with TCJA in force. With TCJA, I am looking at the standard deduction of $29,200 while under the old rules I was able to claim $54,000 between exemptions and itemized deductions. As a result, my taxable income under the old rules was $25,000 less than under TCJA. There is no doubt the brackets and rates are more favorable under the current rules though, and I ended up owing $2,550 more under the old rules than with TCJA rules.  Not great, but way better than owing $10,000 - $20,000 more. The interesting thing is that almost the entire $2550 I paid more under pre-TCJA is accounted for in the lower tax brackets, specifically the old 15% bracket which is now taxed at 12%. The taxable income above that only netted to a few hundred dollars difference.


Again, this is not to say this will happen with your situation. In general, pre-TCJA rules will likely result in a lower taxable income because of how much easier it is to claim itemized deductions combined with personal exemptions. However, that taxable income is taxed at higher rates with the pre-TCJA rules. It will really depend on where you fall on the income scale and, more importantly, how many exemptions and deductions you can claim.


What can you do now?

As I stated at the beginning of this post, I don’t try to predict how these things will play out. I have to do deal with the current facts and make plans based on those while recognizing that there may be change coming. With that said, we have no real idea what changes may come to tax policy after the election so what we know for now is that the current lower rates are in play for 2024 and 2025.


Moving income into the next two years may be a beneficial strategy. We know the 22% and 24% brackets are bigger than the previous brackets and are at a lower rate so here are some ways to capture more money today at these rates:

  • Roth conversions, where you move funds from an IRA to a Roth IRA and recognize the amount of that move as income is a way to move income from future years to the next two years.

  • If you are sitting on equity comp or capital gains, it could be beneficial to bite the bullet and realize that income before rates go up.

  • Forgo deferred compensation and take that income now.

  • Forgo certain itemized deductions until 2026 when you are more likely to be able to itemize.

All of these are possible options but will depend on where you are at on the income scale, expected deductions and where you may be sitting from an income position over the course of the next ten years to see if these make sense for you.


It will be interesting to see how all of this plays out over the next 12-18 months. Either way, there is a strong likelihood that more changes are coming. Stay tuned to see how those changes will impact you.


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