The New Tax Law: Changes to Brackets, Rates, Deductions, Credits, and Other Basics

Tax Brackets and Rates

Tax brackets specify the percent of tax someone will pay on taxable income based on filing status (single, married filing jointly or separately, or head of household). When a taxpayer falls in a particular tax bracket, it does not mean that he or she will pay the resulting percentage on all income. The tax brackets divide income into portions, and the tax rates apply to only those portions of income. So a taxpayer’s “tax bracket” refers to the rate applied to his or her highest portion of income.

For example, a married couple with $150,000 of taxable income falls into the 22% bracket. They will pay 10% on their income from $0 to $19,050. From $19,051 to $77,400, the rate paid is 12%. The rate of 22% is paid only on the taxable income from $77,401 to $150,000. This results in a tax bill of $24,879, which is 16.6% of the taxable income.

The change that affects the most taxpayers is the reduction in tax brackets. While there was a possibility that the number of brackets would be reduced to three or four, it ultimately stayed at seven. However, the rates are mostly lower than they would have been under the old law. The highest marginal tax rate is now 37%, where previously it was 39.6%. The thresholds for each bracket have changed as well, as the IRS typically adjusts income levels each year to account for inflation.

Short-term capital gains on assets held for one year or less are taxed at the same rate as ordinary income. Long-term capital gains on assets held for more than one year are taxed at much more favorable rates. The capital gains rates have stayed the same as before: 0%, 15%, and 20%. Under the old tax law, the capital gains rates matched up with the tax brackets, with 0% applying to the lowest two brackets, 15% for the next four brackets, and 20% for the top bracket.

Now, under the new law, the capital gains rates do not match up with the tax brackets. The 0% rate applies to those whose ordinary income tax bracket would be 12% or less. The 15% capital gains rate applies to those who have ordinary income tax rates starting at 12% and continuing partially into the 35% bracket. For filers in the remainder of the 35% ordinary income bracket and above, the capital gains rate is 20%.

Standard and Itemized Deductions

The standard deduction has increased significantly, which means that many more taxpayers will take the standard deduction instead of itemizing their deductions. For example, the standard deduction for married taxpayers filing jointly went from $12,700 in 2017 to $24,000 in 2018.

Married taxpayers filing separately are eligible for a standard deduction of $12,000 each. However, both of the spouses filing separately must use the same method for deductions, either standard or itemized. For example, if one spouse uses the standard deduction, then the other spouse is unable to itemize and must also take the standard deduction.

The standard deduction for head of household has gone up to $18,000. This is higher than the deduction for a single person, which is $12,000. Head of household may be used by a single person with a qualifying child or dependent.

As a result of this change, many taxpayers who previously itemized their deductions will now take the standard deduction instead. No longer will they deduct things like mortgage interest, real estate taxes, state income taxes, and charitable contributions. This will make their tax filings much simpler.

Marriage Penalty

We often hear about the marriage penalty in the tax law, but a marriage bonus is possible too. That is, the combined tax bill of a married couple could be higher or lower than their individual tax bills would have been if they had remained single.

A marriage bonus occurs when two people with disparate incomes marry. If a higher-income person marries a lower-income person and files jointly, the combined income sometimes keeps the couple in a lower tax bracket than the higher-income individual would have been in as a single filer. This results in a lower tax bill overall.

The marriage penalty could occur when two people with similar incomes marry. The “penalty” results when the combined incomes of the parties push them into higher tax brackets than they would have been in as single filers. However, under the new tax law, the marriage penalty has been eliminated for most married couples. This was done by making the tax brackets for married people exactly double those for single people.

Those affected by the marriage penalty under the new tax law could be low-income couples or very high-earning couples. The low-income couples would generally be affected because of the Earned Income Tax Credit (EITC). The combined incomes can push the taxpayers into the range where they will receive a smaller credit.

Very high-income earners can feel the marriage penalty because the top married income tax bracket of 37% is not exactly double that of the single filers. Individual taxpayers fall into the 37% bracket with taxable income of $500,001 and greater. The 37% tax bracket starts at taxable income of $600,001 for married taxpayers, which causes the marriage penalty.

By way of example, consider a married couple with incomes of $300,000 and $400,000. Individually filing, they would each fall in the 35% tax bracket. However, if they married, they would suddenly be in the 37% tax bracket because of their combined income of $700,000. Thus the married couple pays higher taxes—a marriage penalty.

Marital Status

The new tax law has not affected the rules surrounding marital status and filing of taxes. The marital status of the parties on the last day of the tax year determines how they file their taxes for that year. Taxpayers are generally considered to be unmarried for the year of the tax filing if on the last day of the year they were either unmarried, legally separated under a separate maintenance decree (rules vary by state), or divorced under a final decree.

Taxpayers who are in the process of divorce will file as married if, on the last day of the year, they are married and living together or married and living apart but not legally separated. The taxpayers would typically file as married, either jointly or separately. However, a married person might be able to file as head of household if he or she is “considered unmarried” under the IRS rules on the last day of the year. To qualify to file as head of household, the taxpayer must file a separate return, must have lived apart from the spouse for the last six months of the tax year, and must pay more than half the cost of keeping up his or her home for the year; in addition, the home must have been the main home of the qualifying child for at least six months of the year. Usually, the primary residential parent is considered to be the one who provided more than one-half of the child’s support, regardless of who made or received support payments. To be safe, the client should always check with his or her accountant.

Dependency Exemption

Previously, there was a deduction referred to as an exemption. The taxpayer received one exemption for himself or herself, and one exemption for each qualifying dependent. Most recently, each exemption reduced taxable income by $4,050. This dependency exemption has been eliminated under the new tax law, so, through 2025, parents will no longer fight over which parent is to receive this tax benefit. However, tax credits for the children and head of household filing status (discussed above) might still be an issue.

Kiddie Tax

In the past, the “kiddie tax” (the income tax on a child’s investment income) was calculated based on the parents’ income tax rate. This was because the child’s income tax rate is usually lower than the parents’ rate, and the IRS wanted to prevent parents from shifting investment income to an individual with a lower tax rate.

With the new tax law, the kiddie tax will no longer be based on the parents’ income tax rate, but instead will be based on the tax rates for trusts. Unearned income (such as dividends and interest) and short-term capital gains will be taxed as ordinary income using the trust rates. Long-term capital gains and qualifying dividends will be taxed at capital gains rates.

The trust tax rates are high and the brackets are low. The rates start at 10% for ordinary income up to $2,550, and go up to 24%, 35%, and 37%. The 37% bracket starts at income of only $12,500. On long-term capital gains and qualified dividends, the rates are 0%, 15%, and 20%, with the top rate kicking in at income of $12,700 and over.

While it looks like the new kiddie tax rules are setting up many to pay larger tax bills, that won’t necessarily be the case. It is all going to depend on how much income we are talking about. Suppose a child has long-term capital gains income of $10,000 and her parents are at the 35% tax bracket. Under the old rules, the child’s tax liability would have been much higher than it will be under the new rules. Ultimately it depends on the level of income and whether the income is taxed as ordinary income or long-term capital gains.

Child Tax Credit

The child tax credit has gotten more valuable for 2018 and beyond. Tax credits are much more advantageous than deductions because they are a direct reduction of tax, rather than just a reduction of the income on which the tax is calculated.

Under the old tax law, the child tax credit was up to $1,000 per qualifying child. It was available to taxpayers with earned income of at least $3,000 and was phased out for taxpayers with adjusted gross incomes of $75,000 (single) or $110,000 (joint).

In 2018, the child tax credit goes up to $2,000. To qualify, all of the following tests must be met:

• The child must be under age 17 at the end of the tax year.
• The child must be a U.S. citizen, U.S. national, or U.S. resident alien.
• The taxpayer must be able claim the child as his or her dependent for tax purposes, even though the dependency exemption has been eliminated.
• The child must be a daughter, son, stepchild, foster child, sister, brother, stepsister, stepbrother, half-brother, half-sister, or descendant of any of these people. An adopted child is considered a taxpayer’s own child.
• More than half of the child’s support must not have been provided by the child.
• The child generally must have lived with the taxpayer for more than half of the tax year, although there are some exceptions.

A Social Security number for the child is required to be provided in order to claim the entire allowable credit. If the child does not have a Social Security number, the taxpayer may still claim a $500 nonrefundable credit if the other conditions are met. The taxpayer may also claim a $500 credit for each dependent who is a qualifying relative but not a qualifying child.

In addition to doubling the credit, the new tax law offers some additional, advantageous features. Up to $1,400 of the tax credit will be refundable, meaning that even if the taxpayer has no tax liability, he or she will be refunded part of the credit. Low-income taxpayers will benefit from this. The income levels at which the credit is phased out have been increased, which means more taxpayers will benefit. In 2018, the child tax credit doesn’t start to be phased out until $200,000 of adjusted gross income for single filers and $400,000 for joint filers. The credit goes away completely at adjusted gross income of $240,000 (single) and $440,000 (joint).

529 Savings Plans

Qualified tuition plans, commonly known as 529 savings plans, encourage savings for education costs by offering tax advantages. While the contributions to 529 plans are not deductible, the investments grow tax free so long as withdrawn funds are used for qualified education expenses.

Under the old tax law, 529 funds could only be used for qualified higher education expenses. The new tax law allows the funds to be used for higher education as well as for private elementary or secondary school tuition up to a maximum of $10,000 per year per beneficiary. In addition, the funds may be used for qualified expenses such as computers, Internet access, tutors, and online classes.

This change alters the financial planning landscape. It could cause 529 plans to be depleted quickly; while the funds previously would have accumulated until a child was college age, now they may be used when a child enters elementary school, and they may be exhausted before a child is even out of elementary or high school. Also, one or both parents might be unwilling to pay for private school as part of support, opting instead to just utilize the 529 funds. While the support-paying spouse might benefit from this approach, the child could be left without college funds. The long-term impact of using 529 funds for elementary or secondary school should be carefully considered.

Gift Tax

The new tax law changed the 2018 federal estate and gift tax exemption to $11,180,000 per person. This means that a married couple can shelter double that amount, or $22,360,000. This is more than a twofold increase from the 2017 exemption level, which was $5,490,000 per person.

The annual gift exclusion went from $14,000 in 2017 to $15,000 in 2018. In other words, up to $15,000 can be given to each person by a taxpayer with no gift tax due. However, the total amount gifted during a taxpayer’s lifetime will count against the lifetime estate and gift tax exemption of $11,180,000. If a taxpayer gifts a child a sum greater than the annual gift tax exemption amount ($15,000/child), he or she must file a gift tax return. Check to see whether these annual amounts increase in 2019 and beyond. Taxpayers should track their annual gifts (an Excel spreadsheet is helpful) to make sure they remain below the maximum exemption level.

Conclusion

Many provisions in the new tax law will be advantageous to taxpayers. For example, one of its goals was simplification of filing for many taxpayers, and that was achieved with the large increase in the standard deduction. Other changes offer significant tax savings. When drafting divorce agreements, however, attorneys will ideally try to predict the unpredictable—how the tax code’s treatment of deductions and credits will shift after the TCJA’s 2025 expiration date. Attorneys will at least need to prepare to review those agreements after that date and to adjust them, if necessary and possible.