USING YOUR TAX SAVINGS WISELY
As the April 17 tax filing has come and gone, one thing on the mind of many taxpayers now that they have caught their breath, is how much more or less their tax liability will be as a result of the Tax Cuts Jobs Act (TCJA) -- also know as the new tax law enacted by the Trump administration. According to Howard Gleckman of the Tax Policy Center, about 80% of taxpayers will see a reduction in their tax liability, but about 5% will notice an increase in what they owe. The remaining 15% of taxpayers will pay roughly the same amount in 2018 (filed in 2019) as 2017.
Financial Impact of Tax Reform (2018)
Gleckman goes on to point out that the average household will realize a tax cut of about $1,600 next year. Keep in mind these numbers are strictly averages. To get a rough estimate of what you might save or pay in taxes in 2018, click the following TCJA Tax Table Guide.
A more thorough way to plan for what you might save or owe starting next year is to leverage the tools and software available online through websites like dinkytown.net. Or better yet consult directly with a tax planning expert, such as CPA or CFP®, who can provide the most detailed analysis.
Why is planning ahead so critical? Once that money is earmarked for other goals, it becomes a lot harder to spend. Many of us, myself included, have a tendency to cash in our tax savings on fun things like travel or home improvements. This especially holds true without a financial plan. Don't get me wrong, using a portion of your savings for the "wants" in life is needed to keep your sanity, but do yourself a favor and pay yourself back too.
My hope is that readers of this article will see the value in taking more proactive measures to leverage some portion of their anticipated tax savings. To that end, the following case study that I am about to introduce primarily focuses on strategies you can use with your tax savings.
Keep in mind that it is equally as important to prepare if you end up owing more as a result of tax reform. No one likes negative surprises, especially when it comes to their money. So do yourself a favor and plan for what is already starting to take effect.
One last tip before we jump into the case study... Many taxpayers may want to adjust their withholdings. To do so, click this link to recalculate how much you should withhold on your W4.
Case Study - Meet The Mitchell's
Henry and Alice Mitchell are 43 and 41 respectively, and have a high-energy only child, Dennis who can be quite the menace. Dennis, age 7, attends private school at Episcopal School of Jacksonville. The Mitchell's believe Dennis will benefit from a more formal and structured educational environment, but aren't sure if they can continue to afford paying private school tuition.
With that in mind, the Mitchell's are seeking the advice of a Certified Financial Planner®. They recently inherited $130,000 from their good friend Mr. Wilson and aren't sure what to do with the funds. In addition, the Mitchell's are concerned about the recent tax changes and how the TCJA will impact their financial situation.
Henry is particularly worried that he and Alice are going to have to pay more when they go to file their taxes in 2019. Henry's anxiety primarily stems from a conversation he overheard one morning by the water-cooler... One his fellow law partners mentioned that he and his wife were no longer able to itemize deductions because of the $10,000 cap on SALT deductions.
Overhearing this discussion prompted Henry to insist that he and Alice speak with an expert. The last thing they want to have happen is getting blindsided by the impact of tax reform. Consequently, Henry and Alice were referred to a local CFP® in the Ponte Vedra area who could help them get a better handle on their entire financial picture.
Upon the conclusion of their initial consultation, it was clear that the Mitchell's put off several goals for quite some time. The following is a summary of the Mitchell's primary concerns:
- How much more or less in taxes will they pay as a result of tax reform?
- If less, what should they do with their extra funds?
- If more, should Dennis attend public school?
- Will they be itemizing their deductions like in year’s past or taking the standard deduction?
- What changes should be kept in mind if they no longer itemize?
- Henry read somewhere online that a Roth IRA is something he and Alice should have. Can and/or should they be contributing to one?
- Henry was previously told by another stock broker that he and Alice make too much money and don't qualify for a Roth IRA. The Mitchell's would like this matter confirmed.
- Alice is very concerned about the rising cost of college tuition. Therefore, she would like advice about the best way to save for college while paying for Dennis' private school.
Household Net Worth & Income
Together a household's net worth and income will dictate the tax liability that is generally owed. The higher a family's net worth and income are, the more emphasis on things like capital gains and dividends, as well as tax-sheltered vehicles like 401k plans and IRAs.
The figure below is summary of the Mitchell family's net worth, which amounts to $811,394 once their emergency savings of $40,000 is added in with everything else. Furthermore, now that the Mitchell's have finally paid off their student loans and credit cards, he and Alice can comfortably save $15,000 per year towards other goals.
The Mitchell's are clearly good savers. It helps that their household income is $320,000 -- Alice, a nurse, makes $80,000 and Henry, a law partner, earns $240,000. Under the old tax code, the Mitchel's tax bracket was 33%, however, as a result of the Tax Cuts Jobs Act, the Mitchell's new tax bracket is 24%.
Given the 9% difference in marginal tax rates, it would appear the Mitchell's are going to save a chunk of money on their taxes (at least for the next 8 years, until the TCJA sunsets). However, to be sure, the prudent thing to do is to plug all dollar amounts relevant to the Michell's situation into the IRS 1040 tax filing form -- using both the old rates and the new tax rates. Doing so will ensure we have a more definitive answer. For the do-it-yourself types, you can estimate your 2018 tax returns using this calculator.
Before we compare the results and run everything through the IRS 1040, we also need to know more about other tax sensitive factors. Things like retirement contributions, investment assets, and mortgage interest, which are outlined below.
Tax Sensitive Details
- Pre-tax Retirement Accounts = $450,000
- Includes 401(k) plans and Traditional Rollover IRA
- Both Alice and Henry save 10% of their gross income into their 401(k)
- Joint Brokerage Account = $130,000
- Brokerage money was recently inherited from Mr. Wilson, therefore all stocks and mutual funds received a step up in their cost basis (i.e. capital gains = $0)
- Alice would like to earmark the inheritance for Dennis' college fund
- Taxable Dividends, Interest, and Capital Gains = $8,000
- Loan Amount = $383,606
- Monthly Payment = $1,927
- Mortgage Interest + Property Tax Deductions = $19,733
Tax Liability Comparison
Okay now that we finally have gathered all the key information about the Mitchell's it is time to compare their tax liability from the old tax system versus the new system. The following two IRS 1040 snapshots illustrate this tax comparison, with the first illustration calculating the total tax amount owed under the old tax code, and the second figure showcasing the Mitchell's total tax liability using the new tax code.
1040 - Old Tax System
1040 - New Tax System
The following is a rundown of the key differences and what is driving the Mitchell's tax savings (also circled in the illustrated figures above):
- Negative Side Effects
- The Mitchell's no longer itemize their deductions -- $24,000 is greater than their itemized deductions of $19,733 (this is mainly a result of the standard deduction for married couples went from $13,000 to $24,000)
- Personal exemptions are gone -- went from $12,450 to $0
- Positive Side Effects
- Child tax credit increased from $0 to $2,000
- Marginal tax rate decrease of 9%
What a relief to the Mitchell's. At first they expected to pay a higher amount in taxes, but in reality tax reform saves them just under $10,000 a year (rounded up from $9,809). In other words, the Mitchell's will save about $80,000 over the next 8 years while tax reform is in effect. It's amazing how quickly money can add up or disappear, depending on how you frame it. Now that the Mitchell's are aware of this newfound savings, they can ensure it gets used wisely.
How can the Mitchell's better maximize their tax savings and other financial resources?
With the recent influx of cash from tax reform and the inheritance from Mr. Wilson, the Michell's are able to go several different directions in terms of what they do with the money. However, given their goals and objectives previously mentioned, there are 3 planning opportunities that stand out:
- Partial Roth Conversions
- Convert inherited brokerage account into a 529 college savings plan
- Use excess savings to accelerate paying down the mortgage
Other planning opportunities might include changing their 401(k) contributions from pre-tax to Roth, putting the excess savings into a brokerage account and dollar cost averaging, bunching charitable contributions using a donor advised account, or setting up an Uniform Gift to Minors Account (UGMA) for Dennis. While these are worthy considerations, the previously highlighted strategies are what we will be focusing our attention on due to their financial impact, as well as the way in which they solve the Mitchell's goals.
A closer examination of the planning opportunities
1) Partial Roth Conversions
The biggest value-add to the Mitchell's is what is know as partial Roth IRA conversions. The mechanics of such a strategy require the IRA owner to convert pre-tax IRA and 401(k) dollars into after-tax dollars that are now held under the Roth umbrella. Having money sheltered through the Roth allows those funds to grow tax-deferred and any future earnings can be withdrawn tax-free starting at age 59 1/2.
As you recall, one of the Mitchell's questions was, "should they open a Roth IRA?" The answer is unequivocally "yes." However, the challenge the Michell's face is that they make too much money and are phased out of being able to contribute to a Roth. However, using partial Roth conversions is a workaround strategy that works really well when the account holder is able to pay taxes on the conversion amount out of pocket from savings instead of deducting the taxes owed from the sum of cash being converted from the pre-tax retirement account (traditional IRA or 401(k)).
The best way for the Mitchell's to apply their partial Roth conversion strategy is to use their $10,000 annual tax savings as a means of paying the conversion tax and "filling up their tax bracket" to the top end of their marginal tax rate. In other words, the Mitchell's should keep their conversion sum within the 24% marginal tax bracket income range and avoid their income hitting the 32% marginal tax rate. So including the conversion amount, the Mitchell's total taxable income should not exceed $315,000 (the beginning income range of the 32% tax rate) because anything higher requires paying 8% more in taxes (32% - 24% = 8%).
With all of that in mind the question becomes, how much should the Mitchell's be converting on an annual basis? As outlined below, converting $41,677 of pre-tax IRA and 401(k) funds per year allows the Mitchell's to stay in the 24% bracket and not spend past their $10,000 annual savings that resulted from tax reform.
*Fact Check - Income Tax and Conversion Calculations:
- Conversion Sum = $10,000 tax savings / 24% tax rate = $41,667 conversion amount
- Taxable Income = ($320,000 wages + $8,000 dividends) - $32,000 pre-tax 401(k) contributions - $24,000 standard deduction = $272,000 taxable income
- We want $315,000 > Taxable Income + Conversion = $272,000 + $41,667 = $313,667
So then what kind of financial benefit does this add over the projected life of the Mitchell's plan? Let's assume a 7% annual return with 3% inflation and all other factors remain constant. The following 2 graphs detail the overall projections while incorporating a Monte Carlo Simulation:
Wow! That's nearly $3-million smackeroos more to the Mitchell's bottom line net worth. Clearly using a Roth conversion strategy is beneficial to the Mitchell's. Some of the contributing factors as to why there is so much value being added include:
- Roth IRAs are not subject to Required Minimum Distributions (RMDs), which means less pressure on taking excessive withdrawals from their pre-tax IRA and 401(k) accounts
- The Mitchell's still have a long way to go until retirement -- most people would rather be taxed on $40,000 than $120,000 (3X the original value in 30 years)
- Whoever inherits the remaining funds (i.e. beneficiaries) does not have to pay taxes on the lump sum received, but is subject to RMDs
2) Convert Inherited Brokerage Account to a 529 College Savings Plan
A point of emphasis to make note of is that the $130,000 sitting in the Mitchell's brokerage account was recently inherited, therefore the securities previously owned by Mr. Wilson receive a step up in cost basis. In plain English this means that the Mitchell's are free to sell those inherited securities while incurring minimal capital gains taxes. This is huge!
Usually when securities are owned for an extended period of time there is a significant amount of long-term capital gains built up. Consequently, it can often be difficult for the owner to sell those securities without paying a large chunk back to Uncle Sam -- making such a transaction cost prohibitive. Most people pay 15% on long-term capital gains for selling stocks and mutual funds, however, those with incomes that fall within the highest tax bracket pay 20%.
Since the Mitchell's are earmarking their brokerage account for Dennis' college, this money is better suited for a college savings vehicle commonly referred to as the 529 Plan. What this does is take money that is currently subject to paying taxes on dividends, capital gains, and interest and placing those funds in a vehicle that allows the money to grow tax-deferred. More importantly, if the money is used for qualified education, the original contributions and the growth can be withdrawn free from income tax.
Note, however, that the annual contribution limit to a 529 Plan without incurring the dreaded gift tax is $14,000 per person and amounts to $28,000 per year for a married couple. Normally, this might put a damper on converting the $130,000 brokerage funds to a 529 Plan. Thankfully, there is an exception to the gift tax issue with 529 Plans that allows each person to contribute up to 5 years in a single lump sum -- $70,000 per person. In other words, the Mitchell's can contribute up to $140,000 to a 529 Plan and are okay to proceed as planned. They just need to be mindful that their $130,000 529 Plan contribution limits their ability to save anything beyond $10,000 over the subsequent 5 years.
So then how does the 529 Plan strategy create a win for the Mitchell's? Assuming a 6% annualized return and 15% capital gains tax rates, the projected value-add is $20,000. Without the tax-sheltered benefits of a 529 plan, the Mitchell's would experience a tax drag on their returns of 15%, which is effectively reducing their annualized growth from 6% to 5.10%.
3) Use the Rainy Day Savings Funds to Pay Down the Mortgage
One of the negative effects of tax reform the Mitchell's discovered is that itemizing deductions provides no economic benefit to them. This is a direct result of the standard deduction being doubled to $23,000, which is a significantly higher amount for most taxpayers to hurdle over. In fact, it is estimated that 9 out of 10 taxpayers will be using the standard deduction. What this means is that there is a little to no benefit with itemized deductions like mortgage interest and property taxes, which under the old tax code carried a lot more weight.
While there is no longer a financial benefit from mortgage interest tax deductions, a strategy that the Mitchell's should consider is accelerating paying down their mortgage. They can do this using the $15,000 per year that they are able to save towards other goals.
Instead of keeping their mortgage payments status quo, if the Mitchell's can take matters into their own hands and pay an extra $1,250 per month ($15,000 / 12). Doing so provides them interest savings of $118,700 and allows them to be debt free by the time Dennis goes to college in 2030. Once the house is paid off, the $1,900 per month they normally paid plus the $1,250 per month extra payments means that $3,150 per month ($37,500/year) is available for other uses. That's a lot of dinero to have at their discretion. Maybe then Henry and Alice can afford that summer cottage in Maine like they had always dreamed about. Obviously, if the Mitchell's cash flow situation changes, they should reduce their payments back to $1,900.
putting it all together
Even though Henry and Alice oftentimes found themselves too busy to meet with a financial planner in years past, they are glad they finally forced themselves to pull the trigger. Not only did their financial advisor alleviate some of the anxieties that Henry had about the new tax legislation, they were also able to get a financial plan in place that maximizes their wealth.
By proactively managing their tax savings and leveraging the aforementioned 3 strategies, the Mitchell's project to enhance their bottom line net worth by nearly $3,125,000. However, the greater value to the Mitchell's is the peace of mind that they get by having an expert by their side every step of the way. Such a relationship really comes in handy when life happens, money exchanges hands, or a massive legislative change occurs.
If you learned one thing from today's article, it is to be proactive and not reactive when it comes to money matters. Be sure to stay tuned for more great tips by coming back to check out The Money Blog.