What is the hardest thing to understand in the world?
A. Quantum physics
C. Rocket science
D. Income tax
At least according to Albert Einstein, who said, “The hardest thing to understand in the world is the income tax.”
Further complicating income taxes is the recently passed Tax Cuts and Job Acts, which represents the largest one-time reduction in the corporate tax rate in the U.S. history and lowers taxes for most Americans, as well as small-business owners.
One of the most significant changes is the increase in the standard deduction. This is the dollar amount that taxpayers may subtract from their taxable income, which reduces their overall tax liability. In 2018, the standard deduction increased to $24,000 for married couples and $12,000 for a single filer, up from $12,700 and $6,350 respectively. Individuals over the age of 65 receive a larger deduction of $15,200.
In lieu of the standard deduction, some taxpayers may choose to itemize their deductions. In 2016, nearly one-third of all taxpayers itemized their taxes because their deductions were higher than the standard deduction, resulting in a larger tax benefit for those deductions.
It is estimated that only 8-to-10 percent of Americans will itemize their taxes in 2018 and they will receive no financial benefit from any of their itemized deductions, including charitable donations.
Here is an example of this change. In previous years, a 72-year-old retired couple who paid $10,000 in state income tax, $10,000 in property tax, $5,000 mortgage interest and $7,000 in charitable gifts would have itemized their deductions. In doing so, they would have $32,000 in itemized deductions versus their $15,200 standard deduction as a couple who is older than 65. In this scenario, the married couple would receive a financial benefit for their deductions and every dollar they allocated to nonprofits would represent a tax benefit.
In 2018, that same couple will now be capped at $10,000 for their combined income and property taxes and their total deductions drop to $22,000. This couple will now opt for the standard deduction of $26,600, which consists of $24,000 plus $1,300 for over-age-65-per-person additional deduction. Taking this approach, they will receive no tax benefit for their itemized deductions, including charitable donations.
If the couple we have highlighted wants to continue making charitable contributions and maximize their after-tax income, they can employ a strategy called the qualified charitable distribution (QCD). The couple can contribute up to $100,000-per-year from their individual retirement accounts (IRAs). Any amount processed as a QCD will count toward their required minimum distribution and will reduce the amount of taxable income from the distribution, which in-turn lowers their income tax liability.
If this couple gives $7,000 from their IRAs directly to nonprofits, they can still receive the $26,600 deduction and reduce their taxable income by $7,000. Assuming the couple is in the 24-percent federal tax bracket, they will save $1,680 in federal taxes alone. This is what we call a win-win-win. The taxpayer can support their beloved causes, receive a financial benefit and give nonprofits more financial stability.
The QCD is worthy of consideration for those with charitable intent who are over the age of 70.5. There are other charitable strategies for those under 70.5 to consider as well, such as donor-advised funds.
Income tax can be a complicated subject; however, with proactive planning, even Einstein could make smart financial decisions.