Note: The is one of a series of articles explaining how the various tax changes in the GOP’s Tax Cuts & Jobs Act (referred to as “the Act” in this article), which passed in late December of 2017, could affect you and your family, both in 2018 and future years. This series offers strategies that you can employ to reduce your tax liability under the new law.
The Act increased the standard deduction and placed new limitations on itemized deductions. Beginning with 2018 tax returns, the standard deductions will be:
- $12,000 for single individuals and married people filing separately,
- $18,000 for heads of household, and
- $24,000 for married taxpayers filing jointly.
If your deductions exceed the standard deduction amount for your filing status, you are allowed to itemize the following deductions:
- Medical expenses, to the extent they exceed 7.5% of your adjusted gross income (AGI);
- Taxes paid during the year (for state or local income or sales tax and for real property or personal property taxes), limited to $10,000;
- Home mortgage interest;
- Investment interest;
- Charitable contributions;
- Gambling losses, to the extent of your gambling winnings; and
- Certain infrequently encountered tier-1 miscellaneous deductions.
Are your itemized deductions typically roughly equal to the new standard deduction amount? If so, think about using a tax strategy known as bunching. In this technique, you take the standard deduction in one year and then itemize in the next. This is accomplished by planning the payment of your deductible expenses so as to maximize them in the years when you itemize deductions. Commonly bunched deductible expenses include medical expenses, taxes, and charitable contributions.
To clearly illustrate how bunching works, here are a few examples of deductible payments that generally provide enough flexibility:
- Medical Expenses – Say that you contract with a dentist for your child’s braces. This dentist offers you the option of an up-front lump-sum payment or a payment plan. If you make the lump-sum payment, the entire cost will be credited in the year you paid it, thereby dramatically increasing your medical expenses for that year. If you do not have the cash available for the up-front payment, then you can pay by credit card, which is treated as a lump-sum payment for tax purposes. If you do so, you must realize that the interest on that payment is not deductible; you need to determine whether incurring the interest is worth the increased tax deduction. Another important issue related to medical deductions is that only the amount of medical expenses that exceeds 7.5% of your AGI is actually deductible. In addition, this 7.5% floor will increase to 10% after 2018. There is thus no tax benefit to bunching medical deductions if the total will be less than 7.5% of your AGI (or 10% beginning in 2019).
If you have abnormally high income in the current year, you may wish to put off medical expense payments until the following year (e.g., if 10% of the following year’s income will be less than 7.5% of this year’s income).
- Taxes – Property taxes are generally billed annually at midyear; most locales allow for these tax bills to be paid in semiannual or quarterly installments. Thus, you have the option of paying them all at once or paying them in installments. This provides the opportunity to bunch the tax payments by paying only one semiannual installment (or 2 quarterly installments) in one year and pushing off the other semiannual (or 2 quarterly) installments until the next year. Doing so allows you to deduct 1½ years of taxes in one year and half a year of taxes in the other. However, if you are thinking of making late property tax payments as a means of bunching, you should be cautious. Late payment penalties are likely to wipe out any potential tax savings.
If you reside in a state that has a state income tax, any such tax that is paid or withheld during the year is deductible on federal taxes. For instance, if you are making quarterly estimated state tax payments, the fourth quarter estimated payment is generally due in January of the subsequent year. This gives you the opportunity to either make that payment before December 31 (thus enabling you to deduct the payment on the current year’s return) or pay it in January before the due date (thus enabling you to use it as a deduction in the subsequent year).
Here is a word of caution about itemized tax deductions: Under the Act, a maximum of $10,000 is allowed under itemized tax deductions, so there is no benefit gained by prepaying taxes when your tax total is already $10,000 or more. In addition, taxes are not deductible at all under the alternative minimum tax, so individuals under that tax generally derive no benefits from itemized deductions.
- Charitable Contributions – Charitable contributions are a nice fit for bunching because they are entirely at the taxpayer’s discretion. For example, if you normally tithe to your church, you can make your normal contributions during the year but then prepay the entire subsequent year’s tithe in a lump sum in December of the current year. If you do this for all contributions that you generally make to qualified organizations, you can double up on your contributions in one year and have no charitable deductions in the next year. Normally, charities are very active in their solicitations during the holiday season, which gives you the opportunity to make forward-looking contributions at the end of the current year or to simply wait a short time and make them after the end of the year. Charitable deductions do have a limit, but for most types of contributions, it is high: 60% of AGI, beginning in 2018.
If you have questions about bunching your deductions, or if you wish to do some in-depth strategizing about how this technique could benefit you, please call for an appointment.