This month, public attention is focused on the banking crises, the Federal debt ceiling, and inflation. But people investing for the long-term should be thinking about taxes. Specifically, how paying more in taxes this year and next will save a lot more in taxes in the future.
We are currently living in an era of historically low federal income tax rates. The Tax Cuts and Jobs Act of 2017 had major effects on federal income taxes for nearly all Americans beginning in 2018. Specific provisions of the law included:
- Across the board decreases in federal income tax rates
- An increase in the standard deduction amount
- Elimination of the personal exemption and reducing the advantages of itemizing deductions, including charitable deductions
- Limiting deductions for state income taxes, local income taxes, and property taxes paid
- Limiting the mortgage interest deduction
- Reducing the number of Americans subject to the alternative minimum income tax
The law was time-limited and expires at the end of 2025. Unless it is renewed or replaced with new legislation, then the federal income tax system will revert to the pre-2018 tax system and this will have a significant impact on most Americans.
The Tax Cuts and Jobs Act of 2017 had the biggest impact on high income families. Taxpayers in the 95th to 99th income percentiles (those with income between about $308,000 and $733,000) received the biggest benefit with an average tax cut of about $11,200 or 3.4% of after-tax income. Although we all love tax cuts, they come with a societal cost and it is estimated that if the law is extended for an additional 10 years, the federal deficit will increase by $3.7 trillion between 2033 and 2042. It is impossible for anyone to predict at this time whether the the law will expire, be renewed, or be replaced. This will depend on the economy, the future federal budget, and which political party controls the legislature and presidency. But for now, there are some steps that you can take today to prevent an enormous surge in your federal income tax in 2026.
Do Roth IRA conversions in 2023, 2024, and 2025.
The best time to do a Roth IRA conversion is when your taxes are lower today than when they will be when you are in retirement. Because it is not possible to predict income tax rates that far in the future, your best bet is to have some money in Roth accounts (Roth IRA and/or Roth 401k) and some money in tax-deferred retirement accounts (401k, 403b, and/or 457). That way, you can selectively take money out of your Roth accounts when tax rates are high in retirement and selectively take money out of tax-deferred accounts when tax rates are lower in retirement. If the Tax Cuts and Job Act of 2017 does expire, then the next three years will be optimal for doing Roth conversions while federal income tax rates are lower. There are two ways to do a Roth conversion. Either convert money already in a traditional IRA (or other tax-deferred retirement account) into a Roth IRA or do a “back-door Roth IRA” by first contributing post-tax money from income this year into a traditional IRA and then immediately converting that money to a Roth IRA. Because any money converted into a Roth IRA is considered taxable income on the year of the conversion, you have to be careful how much you convert from an existing tax-deferred retirement account since the more you convert, the higher your total taxable income will be for that year. As your taxable income increases, so does your marginal income tax rate so you don’t want to convert too much or the increase in this year’s federal and state income taxes could offset the long-term benefit of the Roth conversion. A reasonable strategy is to do smaller Roth conversions in 2023, 2024, and 2025 to avoid an excessively high income tax rate during any one year.
Defer charitable contributions until 2026
The Tax Cuts and Jobs Act of 2017 resulted in charitable deductions no longer being tax deductible for most Americans. Each year, taxpayers can either take the standard deduction or itemize deductions, whichever value is higher. In 2022, the standard deduction was $12,950 for individual filers and $25,900 for joint filers. Most families have less than $25,900 in itemized deductions so most end up taking the standard deduction instead of itemizing. By giving to charity only on every other year or every third year, you can build up the amount of charitable deductions so that your total itemized deductions exceed the amount of the standard deduction. By doing this, you will have a larger total income tax deduction. If your annual contributions to charity are typically in the $10,000 – $15,000 range, then you would be best off deferring your planned 2023 contributions to charity until January 2024 and then making your planned 2025 contributions to charity early in December 2024. The result is that you would have little or no charitable contributions in 2023 and 2025 but a very large charitable contribution in 2024, thus pushing you over the standard deduction limit for 2024. Without congressional action, in 2026, the standard deduction will revert to the previous values which in 2018 were $6,350 for single filers and $12,700 for joint filers at which time, many Americans may find it more advantageous to itemize deductions each year rather than take the standard deduction. If the Tax Cuts and Jobs Act of 2017 does expire, then it may be more advantageous to defer 2025 (and potentially even 2023) charitable contributions until January 2026.
Pay your property taxes January 2026
The Tax Cuts and Jobs Act of 2017 put a cap on the amount of state, local, and property taxes that can be deducted from your federal income taxes. Prior to 2018, the amount that could be deducted was unlimited but after the law, the maximum amount of state, local, and property taxes that is deductible is $10,000. This amount is considered one of the itemized deductions so if your itemized deductions are less than $25,900 (filing jointly), then you must take the standard deduction and cannot deduct your state, local and property taxes. In most communities, property taxes are paid semiannually or annually in arrears. That means that you pay your 2022 property taxes in 2023, for example. The property tax bills are usually sent out in December and then you have until the end of January to pay that tax. If the Tax Cuts and Jobs Act of 2017 does end up expiring, then do not pay your property tax in December 2025 when you get your tax bill – instead wait until January 2026 when you will be able to apply your property taxes paid to your itemized deductions, thus reducing your 2026 taxable income when the marginal tax rates increase.
Pay your mortgage installment in January 2026
Mortgage interest is also considered to be an itemized deduction. Most mortgage payments are due on the first of the month. If possible, make your monthly mortgage payment on January 1, 2026 rather than in late December 2025. This will add to your itemized deduction in 2026 when you will get a better tax benefit from itemized deductions. If you plan to cluster your 2023, 2024, and 2025 charitable deductions all in 2024 as described in the earlier section of this post, then use this same strategy for your December 2023 mortgage payment and then also pay your first mortgage payment in 2025 (due on the first of January 2025) a few days early in December 2024. This will maximize your itemized deductions in 2024 thus allowing you to have a higher amount of itemized deductions than the standard deduction in 2024.
Beware of the alternative minimum tax
Prior to the Tax Cuts and Jobs Act of 2026, the alternative minimum tax (AMT) was a shackle on many taxpayers – more than 50% of people with an income of greater than $200,000 per year had to pay AMT. When a person pays AMT, they no longer use the usual income tax brackets to determine their marginal income tax rate but instead use two brackets: 26% and 28%. This resulted in a much higher total income tax paid under the AMT than under the usual income tax schedule. The AMT was mysterious and had many different variables that together could push you into the AMT. Frequently, taxpayers would not know if they had to pay AMT or the lower usual tax amount until they actually sat down to fill out their federal 1040 form in the spring. For this reason, the AMT was uniformly hated by Americans who had to pay it. The Tax Cuts and Jobs Act of 2017 greatly reduced the number of taxpayers who were susceptible to AMT and this substantially reduced the federal income tax for those people who previously paid AMT. When the law expires in 2026, then if no new legislation is enacted, expect to see many more people paying AMT than pay it today.
The triggers that push you from the usual tax system into the AMT are complex and depend on many different variables. Some of the most important are total taxable income, exercising stock options, mortgage interest paid on a second home, high state income tax amounts, and high local income tax amounts. Fortunately, income tax preparation software (such as Turbotax) will do all of the calculations to determine whether you will be hit by AMT. For many years prior to 2018, I was subject to AMT and it added thousands of dollars to my annual tax bill.
Its not too early to start tax planning now
2026 seems like a long way off but for the long-term investor, particularly one investing for retirement, taking the right tax-related steps over the next two and a half years can save a great deal of money in the long-term. The most important steps are (1) to carefully analyze your financial position to determine if you should do Roth conversions and (2) to determine if you would be better off clustering two or three years of contributions to charity in a single year. In two years, we should have a reasonably good idea how economic and political forces will affect the expiration of the Tax Cuts and Jobs Act of 2017 and whether or not it will be replaced with some other tax legislation. Be watching to determine how that will affect the timing of your 2025 property tax and mortgage payments.
As responsible citizens, we should all pay the full amount of taxes that we owe. But, we should not fall prey to paying more than we legally have to.
May 5, 2023