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Taxes are Changing, the 2017 Tax Reform Act

Unless you’ve been living under a rock you already know that congress and the president signed into law a sweeping tax reform bill on December 15. The sweeping changes were sold as a way to simplify and reduce taxes. But will they do so?

We already explored whether fiscal stimulus is a good idea a few weeks ago. So for this post we won’t be investigating the economic impact. Instead I want to provide you some thoughts on the impact of these tax changes on you as an individual or married tax payer.

Tax Brackets have Changed

The first thing to be aware of are tax brackets have reduced across the board. I will focus on married brackets here for brevity but what I say applies to both single and married brackets. The 2017 married tax brackets were:

Taxable Income Bracket Tax Owed
$0 to $18,650 10%
$18,650 to $75,900 $1,865 + 15%* of Amount > $18,650
$75,900 to $153,100 $10,452.50 + 25% of Amount > $75,900
$153,100 to $233,350 $29,752.50 + 28% of Amount > $153,100
$233,350 to $416,700 $52,222.50 + 33% of Amount > $233,350
$416,700 to $470,700 $112,728.25 + 35% Amount > $416,700
> $470,700 $131,628 + 39.6% of Amount > $470,700

2018 Tax Rates will be:

Taxable Income Bracket Tax Owed
$0 to $19,050 10%
$19,051 to $77,400 $1,905 + 12%* of Amount > $19050
$77,401 to $165,000 $8,907 + 22% of Amount > $77,400
$165,001 to $315,000 $28,179+ 24% of Amount > $165,000
$315,000 to $400,000 $64,179 + 33% of Amount > $315,000
$400,001 – $600,000 $91,379 + 35% Amount > $400,000
> $600,001 $161,379 + 37% of Amount > $600,0000

Lower Tax Rates By Bracket

The first thing you’ll note are lower rates across the second through fourth bracket, dropping 2, 3, and 5% effectively. Added to that the 3rd bracket is now much wider, nearly doubling the width of the existing bracket. Effectively even though the top 3 brackets still have the same percentages they will pay less since those upper brackets will cover less of their income. The only group without a tax bracket reduction are those in the 10% bracket, or making less than 19K a year.

Everyone Except the First Bracket Receives a Tax Bracket Reduction

Essentially if you make more than $9.16 an hour full time then you’ll receive an initial tax reduction from this bill. Your mileage may vary due to changes in deductions as we will explore later. At least on paper the biggest winners here are those who were in the lower half of the former 33% bracket, below $315,000 and above $233,000. A sizable portion of their income dropped from 33% to just 24%, for a 9% drop in marginal tax rate.

No More Marriage Penalty

The second biggest winners are married couples other than those in the top bracket. That’s right, the marriage penalty is officially gone. Effective with 2018 the brackets for married are double the size of the individual brackets excluding the top bracket. As such filing married results in the same tax rate as filing separately.

Not a Simpler Tax System

The final interesting thing about these tax brackets is what they do not do, make tax filing simpler. The thought throughout this process was the number of brackets would reduce relieving some complexity in the tax code. It did not work out that way.

Anyway, moving on.

Standard Deduction Brings More Tax Savings to the Majority

The second major change is the standard deduction was effectively doubled from $12K to $24K for married couples. The way taxes work this means the funds for which your taxes are applied against are reduced by a greater number before being paid out against the brackets. The options when you file taxes are to itemize or take the standard deduction. Everyone can take the standard deduction and it requires no special situations or filing. Meanwhile if you choose to itemize you have to meet certain criteria, the most famous example being the deduction for mortgage interest and state sales tax. The thing is unless these things exceed the standard deduction there is no reason to itemize. Knowing this increasing the standard deduction most certainly simplifies the tax code. The more people who take the standard deduction the simpler their taxes. So goal one accomplished.

The Majority Take the Standard Deduction

But what about reducing taxes? Well, according to 2013 tax data 68.5 % of filers took the standard deduction. That means for these people their deductions will double. So yes, at minimum 68.5 % of people received a tax cut from this change.  Unfortunately that still leaves 31.5% of people as former itemizers. Many of these people will still see a tax reduction up until their itemization exceeds $24K. So at least for the majority of people upping the standard deduction will reduce their taxes.

Charities Lose from Tax Reform Act

Unfortunately as always there will be some losers. First some activities like donations allow you to reduce your tax bill via itemization. Increasing the standard deduction increases the cost of these activities to those who now fall into the standard deduction who may formerly have itemized. They essentially become a non tax deductible activity for much of the population, hurting charities that may depend on smaller donations from the middle class.

High Tax and Housing Cost States Lose from Tax Reform Act

The second loser here are those from high tax and housing costs states. The law made home loans of larger than 750K are no longer tax deductible for the portion over $750K. This is down from 1 Million. It also removed the deductibility of Home Equity Lines of credit. Also the state income tax deduction is now capped at $10K. Combined these will cost middle and higher income individuals from those states. That being said some of this may be offset by the standard deduction and reduced tax rates. This is not surprising given which groups supported the current administration’s campaign.

Child Tax Credit and Personal Exemptions

The 2017 Tax reform bill removed personal exemptions. These reduce taxable income by amount equal to $4000 times each member of your household similar to a deduction. The net impact under the old law was a reduced tax bill of 4000* number of house members * your tax bill. In this case number of members of your household includes everyone including yourself. So a family of four would have $16,000 in deductions. On the face of it this is a major loss, and it is for those who don’t have kids, albeit blunted by the number of exemptions they had in the first place. But for those who have kids there may be some relief.

With one hand congress took away personal exemptions worth $16,000. With the other they expanded the availability and amount of the child credit. The tax bill increased the credit to $2,000 a child from $1,000. Income limits were also raised from $110,000 to $400,000. Finally $1,400 of the credit was made refundable, i.e.. if you paid in less than $1,400 in taxes you could reduce your taxable liability below 0, meaning the IRS would owe you money. This more than makes up for the loss in personal exemptions for those who have kids.

To calculate the equivalent tax deduction to a tax credit you must first divide it by a person’s tax rate. So a $2000 tax credit at the 24% rate would be the same as a $8,333 deduction ($2000/.24). In essence a single child would cover 2 personal exemptions in the mid 24% bracket. 2 children would more than make up for the loss of personal exemptions. Furthermore, The lower the tax bracket the higher the exemption deductible offset. So the big winner here are those under 400K with 2 or more children. The losers are adults without children, though moderately. Those over the threshold did not lose for the most part since the personal exemption was already phased out. This doesn’t appear to make the tax code simpler since it trades a credit for a deduction.

Small Business Pass Through Deduction

The final major tax reform is for all those freelancers out there. To offset the favorability of corporate tax deductions congress threw small businesses a bone. This includes all types of small businesses with pass through income including sole proprietorships, LLC, S-Corps, and C-Corps. Essentially any business with income after qualified expenses has the potential to deduce 20% before being applied to a persons personal taxes. So for example if I have a side hustle that makes $50K after applicable expenses then in theory I can deduct 20% of this off top before my itemization or standard deduction. My side hustle contribution to AGI essentially is reduced by $50K*.2= $10K. This is great for those side hustling or running a small business in low to mid incomes.

High Income Small Business Pass Through Deduction

Things get a bit more dicey for those in the higher incomes. There are two limitations to this deduction. The first is type of business. If the business is considered a service business or essentiatially “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.” then there is a personal income threshold where it slowly phases out and ultimately can not be taken. If you own one of these businesses and your household income exceeds $315,000 (157.5K for individuals) then the amount phases out.

A side note, there is an exception made for businesses that meet the above definition except are engaged in engineering or architectural services. On an aside, not that my household exceeds a $315,000 AGI, but if we ever did depending on the IRS definition of engineer we might be exempt from this rule. So mid to low income small business and freelancers also will see reductions from this bill.

Calculating the Phase Out

For those in my audience above the thresholds listed here but in the phase out, the following occurs. The first is determine the percent above the threshold limit to determine the remaining threshold percent. The phaseout ends at 207,500 for individuals and 415,000 for married filers. So a married individual has 100K from the threshold to being ineligible. Determine the amount over the threshold they made. So if they made $350,000, they are over the threshold by 350,000-315000= 35000. 35,000/100000=43.75% above the threshold, or 56.25% of the deduction remaining. Then take that percent and multiply it by your bet business income. Then multiply the result by 20%. So 350,000*.5625*.2=$39,375 in deduction. The deduction is based on the pass through amount to the individual. Even in the phase out period these people will be ahead over the lack of such a deduction last year. Unfortunately the big loser here are those running these type of business above the ultimate threshold, they get nothing.

Pass Through Can Be Complex at Higher Incomes

A note on complexity. For those in higher tax brackets running others types of businesses the government added some more complexity here. If you run some other type of business and exceed $415,000 for married individuals or 207,500 for single then certain cutoffs exist based on capital or wages. These ensure the reductions is less then the greater of 50% of W2 wages or W2 wages +2.5% for real estate. (these also technically apply for those running a service business above $315K married or 207,500 individual, but are less likely to be encountered) You can find out more about this part of the  law here. I suspect most of my readers will be covered by one of my first 2 sections on this bill so I won’t belabor this area significantly.

Ultimately though the bill seems to be designed to force c-corps and s-corps to pay out wages. It also seems to provide quite the benefit to low to moderately high income freelancers and self employed individuals. No one really loses, but some at the high end may not win.

Tax Reform in Summary

So that does it for the roundup of the major changes. There are plenty of smaller changes you can read about here. Ultimately I come to the conclusion most people will come out ahead from this tax bill. Those who are from low tax states with mostly paid off homes, 2 or more kids, and a small business like ourselves will be amongst the biggest winners. I am happy that our tax bill may go down as much at 25%, but I also realize I appear to have been lucky enough to be sitting in the sweet spot this time. This says nothing of whether I approve of the bill, but since it is signed I will do my best to make it work for us. Hopefully you, my audience, will also see a significant reduction in taxes, or are positioning yourself to do so.

How will the bill impact you?

13 Comments

  1. Matt @ Optimize Your Life
    Matt @ Optimize Your Life January 3, 2018

    This is a good, thorough summary. Thanks for laying it all out like this.

    My only addition would be the switch to chained CPI, which I think is being drastically undercovered. Basically, the bill changes the way the brackets are adjusted for inflation so that they grow more slowly over time. This means that we will all be moving into higher brackets more quickly than we would have under the old law. This creates a tax increase on everyone over a longer time horizon, but happens slowly enough that people don’t necessarily notice it. Sort of a boiling frog situation.

    It’s also tough to explain and most people are probably only concerned with what their bill will be next year, so I understand why it isn’t being covered by the news very much.

    • FullTimeFinance
      FullTimeFinance January 3, 2018

      So true on chained CPI. Though given how often laws change and the various sunsetting provisions in the bill it may change before it significantly matters.

  2. Mr. 39 Months
    Mr. 39 Months January 3, 2018

    Any tax bill where the majority of people get to keep their money is a good tax bill, in my opinion.

    The interesting aspect (maybe not to FIRE folks) is the reduced corporate tax rate. Should heat up the economy and help to bring jobs to the US – but many of us are trying to not have jobs!

    Happy new year, everyone!

  3. Congratulations, Bill - now you're a LAW
    Congratulations, Bill - now you're a LAW January 3, 2018

    Hi. Thanks for putting this together in comprehensible format.

    I’m glad they mostly wiped out the marriage penalty, as it’s something I’ve grumbled a lot about over the years (even once suggesting we “legally but not really divorce”, which could have saved us almost $15,000 a year in excess taxes).

    Small nit to pick, though. Although it is mostly wiped out, here are a couple places where it remains, although these won’t likely hit a large percentage of your readers.

    As you already noted, the marriage penalty exists in a big way for the top (37%) bracket. In addition, as a consequence note it still exists on the back end of the 2nd highest (35%) bracket, which goes from 200K-500K for singles, and while for MFJ it starts at 400K (sneakily, looks okay so far) it only goes up to 600K.

    Also, for AMT: $70300 in income is exempt from AMT for singles, but only $109400 (rather than ~ 140K if no marriage penalty) for MFJ. However, the phase-out levels for the amounts eligible for exemption are set at MFJ = 2X single. So, partial victory over the marriage penalty here.

    • Congratulations, Bill - now you're a LAW
      Congratulations, Bill - now you're a LAW January 3, 2018

      Haha, that part of my comment addressing the brackets was pretty dumb – despite writing “In addition, as a consequence note…”, I failed to note “as a consequence” accounts for the whole thing.

      Of COURSE the 35% bracket has to end where the 37% starts.

      Duh – Sorry. Wish I could claim that I need more coffee, but maybe at this point I’ve had too much.

      • FullTimeFinance
        FullTimeFinance January 3, 2018

        AMT certainly is an exception to the Marriage Penalty Rule. Then again it’s impact is slightly less painful due to the standard deduction increase as well.

    • Femme Frugality
      Femme Frugality January 4, 2018

      Lower middle-income parents also face a marriage penalty. Definitely under our current system, and I believe under the new one, too. If you’re not married, one parent can claim the kids as HoH and get the EIC. You can do that with two married parents, too, and claim an increased household size, BUT the combined income is likely to put you further down the bell curve, getting less of a refundable credit.

      Like I said, not a change as far as I understand the non-changes to the EIC. But still a significant marriage penalty for some families under either law.

      • FullTimeFinance
        FullTimeFinance January 5, 2018

        True. It’s certainly still not simple once you dig into credits and deductions.

  4. Congratulations, Bill - now you're a LAW
    Congratulations, Bill - now you're a LAW January 3, 2018

    “Those over the threshold did not lose for the most part since the personal exemption was already phased out. ”

    P.S. Thanks for mentioning this. I get tired trying to explain to people who say, “With 4 kids you must get YUGE tax breaks, over $24000 in personal exemptions plus all that child tax credit!”.

    I’m like, “Um, no, we get $0 personal exemptions and $0 child tax credit”. (not to mention the joys of owing the MC surplus bump to 2.35% and the additional 3.8% MC “surtax”…).

    It seems few people are aware that most of the “tax season candy” gets pulled back for higher earners, between phaseouts of personal exemptions and child tax credits, reductions in deductions, additional taxes.

    Not to mention AMT as it was (and still is for 2017 income taxes).

    Too bad the Congress couldn’t have made this new law retroactive to cover 2017’s income and returns!

  5. Congratulations, Bill - now you're a LAW
    Congratulations, Bill - now you're a LAW January 4, 2018

    Hi again,

    I came back to use your tables to model a 2018 tax return and noticed some cut/paste type errors in your 2018 tax table, in the last two lines.

    “$400,001 – $600,000 [taxed as] $91,379 + 35% Amount > $416,700”
    (should be Amount > 400,000 instead of 416,700)

    “> $600,001 [taxed as] $161,379 + 39.6% of Amount > $470,700”
    (should be 37% instead of 39.6%, and also Amount > 470,700 should be > 600,000)

    Thanks again.

    • FullTimeFinance
      FullTimeFinance January 5, 2018

      Good catch thanks for letting me know. Updated.

  6. Chris
    Chris January 4, 2018

    I think I will make out slightly better. Having home equity debt not tax deductible will force me to take the standard deduction instead of itemize. If I do that, then I might as well pay down the debt since it just got slightly more expensive. Decisions, decisions…..

    • FullTimeFinance
      FullTimeFinance January 5, 2018

      I suspect your not the only one asking that question right now. I’d be curious to see where you land.

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