I've been getting hammered with questions about the new tax law and forums are aflame with discussion about it. So although I generally favor “ever-green” content, I guess I'll have to write about this and do it sooner rather than later. This will be a long post; it won't cover every single change out there, but it will cover the most important ones to you. There will be at least one follow-up post about it as well.
The Politics Behind the Tax Cuts and Jobs Act
First things first, in order for you to understand what happened, we'll have to address the politics of the situation. I'm hesitant to do so because political discussions tend to generate more heat than light, but without at least briefly outlining what happened, a lot of the changes don't make sense. There is no more political topic than tax law changes. It is the ultimate political topic. A political topic is one in which reasonable people can disagree on the best thing to do. In this respect, the Republicans won the overall war, but the Democrats won the PR battle. Apparently they managed to convince Americans that most of their taxes are going up. According to a recent Vox poll, only 14% of Americans believe they'll see a tax cut. That number is probably closer to 86%, but most Americans, including many financially savvy doctors on this site, don't actually understand how the tax bill works. Will the tax bill for some people go up? Yes, but it is a very small percentage, and they're in all of the tax brackets (and mostly in high tax, high COLA states.)
The second aspect of politics that you need to understand to “get” what happened is that the Democrats decided not to work with the Republicans and the Republicans decided not to work with Democrats. So that means the Republicans had to get all of the votes required to pass this things themselves, a bit like when PPACA was passed after the 2008 election. Unlike back then, however, the Republicans didn't have a filibuster-proof majority in the Senate. That means they had to pass the law in the Senate under special provisions that allowed them to pass it with a simple majority. These “Byrd Rules” (i.e Reconciliation) were key to why some things happened and some things did not. This caused some desired changes to be left out or compromised on because they simply couldn't be done under the Reconciliation process. The most important of these was the “sunsetting” of many of the tax cuts in 2027, similar to what happened with the Bush tax cuts. Republicans don't actually believe that a future Congress will let them sunset. They think they'll be made permanent. I think it's hilarious that any politician or American would ever call any tax law “permanent.” This portion of the law combined with a lack of understanding of the tax code is what allowed Democrats to win the PR battle. Democrats could point out that the corporate tax cuts were “permanent” but the individual tax cuts were “temporary.” Well, 10 years is about as permanent as tax law ever is anyway. We'll see in ten years.
The third aspect to understand is that some Republican senators had to be “bought off” to pass the law. This sort of thing isn't uncommon, and used to be far more common before all the anti-pork rules were passed and the 24 hours news cycle and social media put Congress under a microscope. Law-making is a sausage factory. It's not something you want to watch. So you end up with a promise to Senator Collins to do some work on health care, you end up with ANWR being opened to oil development to get Murkowski's vote, you end up with a larger child tax credit to get Rubio and Lee etc. You also ended up with a compromise $10K state income/property tax deduction to get some of the Blue/High Tax state Republicans on board instead of eliminating that completely.
All of those compromises really watered down the tax reform aspect of the package. A major goal of Republican leadership was to simplify the tax code, i.e. Tax Reform. The main concept behind tax reform is dramatically lowering tax rates across the board, but eliminating a lot of the deductions. Theoretically, that reduces the time and expense we all spend suffering through our tax code. There were a few minor reforms, but not nearly as many as I would have liked to see and as near as I can tell, the Republican leadership and President Trump (who wanted us to be able to do our tax returns on a postcard) would have liked to see. Everyone has a pet deduction and doesn't want to lose it, but taken together, all of our pet deductions have made a monstrosity. This is all politics. We all want government to do more for us, but we don't want to pay for it. We'd all rather spend someone else's money.
Finally, it must be acknowledged that there is a philosophical difference between the parties. One believes firmly that you can better decide what to do with your money than government can and generally advocates for a less progressive tax code. The other party believes that a larger government can make life better for all of us and advocates for a more progressive tax code. It should be no surprise to any of us when that first party is in power and passes laws that the code becomes less progressive and when the second party is in power and passes laws that the code becomes more progressive. That's just politics. As President Obama famously said, “Elections have consequences.” This election did have the interesting effect of seeing Democrats posturing as deficit hawks, the usual position of the Republicans. But again, that's just politics. When Democrats want to spend more, the Republicans scream about the deficit. When Republicans want to cut taxes, the Democrats scream about the deficit.
With that lengthy explanation of the politics behind all of this, let's leave politics behind for the rest of this post (AND THE COMMENTS SECTION–I'll be deleting all comments related to politics there.) But I think it really is critical to have a basic understanding of the politics of the process to make any sense of the rest of this. Now take a deep breath, realize that your political opponents are your fellow Americans with a simple difference in opinion rather than Nazi stormtroopers or Communist fools, and let's talk about how this will affect the financial lives of doctors.
Corporate Tax Reform
The biggest changes in the tax code are changes to the corporate tax code. I'll gloss through these because they don't have as direct of an effect on your life as the changes to the individual tax code. There is a major political argument here between the two parties. Republicans believe lowering the tax burden on corporations will help the American economy. Democrats see it as a giveaway to the wealthy. A bit of perspective on this topic. First, corporations are us. Just like raising tariffs to pay for government is just a different way to tax us (raising the cost of what we buy), taxing corporations is just a different way to tax ourselves. You can charge tariffs, tax corporations, or tax individuals. It's really all the same. If one method results in a more efficient way to accomplish what needs to be done, wonderful. But neither politicians nor economists can agree on this topic and I'll be honest, I have no idea what the right combination of tariffs, corporate taxes, and individual taxes is. There is no doubt that taxing corporations less makes our tax system LESS progressive, since wealthier people tend to own a larger percentage of corporations. But those are also the same people paying most of the individual tax burden.
The main changes here are lowering the maximum corporate tax rate from 35% to 21%, eliminating the corporate Alternative Minimum Tax (AMT) and making it more advantageous for corporations to bring money that has been kept overseas back to the US. These changes should show up in your portfolio as better returns on your stocks. This is likely a major reason for the excellent stock market performance in 2017. I still don't see a good reason for doctors to form their own C corporations. Even if you're only paying 21% on your corporate tax returns, you're likely going to be paying 23.8% on the dividends from that corporation. 44.8% is definitely more than the top individual bracket.
Pass-Thru Entity Deduction
This topic is of sufficient importance to physicians that I will be hitting it in its own blog post coming up, but we'll hit it briefly today. It isn't just C corporations that are getting a break. It is also pass-thru entities such as sole proprietorships, partnerships, LLCs (taxed as sole proprietors, partnerships, or S corps), and S Corps. The idea here is that you get a deduction for a portion of your business income. That is NOT the income you pay to yourself as salary. It's the rest of it. Many docs and other small business owners have been doing this for a long time in order to save payroll taxes by taking an “S Declaration” (turning a C corp or an LLC into an S Corp for tax purposes.) You split your profits into salary and distribution and only pay payroll (SS and Medicare) taxes on salary. Well, now that pass-thru business income (both salary and distribution) qualifies for lower income taxes too. Basically, you get the lower of 20% of the business income or 50% of what you paid in salaries as a deduction. So, for example, if WCI, LLC makes $1 Million and pays $300K in salaries in 2018, then it's deduction would be the lower of 20% * $1M = $200K or 50% * $300K = $150K. Given our 37% bracket, that deduction would be worth 37% * $150K = $55,500 off of our tax bill. Actually, it's even smaller than that. That 20% number isn't calculated on the business's gross profit, but on your taxable income. Complicated, I know, but suffice to say there will be some deduction there.
Unfortunately, Congress hates doctors. Don't feel too badly. It also hates lawyers, accountants, and financial advisors (but not engineers or architects or bloggers.) These “service businesses” have this deduction severely limited. As long as your taxable income is under $157,500 ($315,000 married) you're fine. You take it just like non-service businesses. Between $157,500 and $207,500 ($315K-415K married) of taxable income, it phases out. Above $207,500 ($415K) you don't get ANY deduction, even on the first $207,500 ($415K) of pass-thru income. So lower paid doctors, lawyers, accountants, and financial advisors are likely to see a deduction, but higher paid ones will not. It's going to be a major tax preparation hassle going forward and will make it a little harder to do your own taxes. Which will cause more docs to hire accountants. Which will cause the accountants to make more money. Which will cause them to be phased out of this break too. One vicious circle.
[Update: Note this section has been updated since publication (and may see more updates as we all figure this out.)]
Higher Standard Deduction
Let's get into the stuff that is a little easier to understand. The standard deduction is rising from what would have been $6,500 ($13,000 married) to $12,000 ($24,000 married.) That's a good thing for tax reform and is good tax policy. More people will take the standard deduction and not have to track all the Schedule A (itemized) deductions. In fact, my family will be using the standard deduction in 2018 (probably only for 2018 though) after “bunching” property taxes and charitable contributions into 2017. Overall, estimates are that 70% of taxpayers will take the standard deduction in 2017 and 90% will do so in 2018.
No More Exemptions
Exemptions are now gone. Basically they were rolled into the standard deduction. If you had three family members or fewer, you come out ahead. Four or more, you're now coming out behind on that point, unless you're a high earning doctor [AGI of $261,500 ($313,800 married)] and were phased out of those deductions anyway. So low earning doctors with large families are hurt by this. Low earning doctors with small families and high earning doctors were helped by this. It's probably good reform though as it simplifies things.
Child Tax Credit Increase
This one helps those low earning doctor families with lots of kids. The credit is increased from $1,000 to $2,000 per child under 17. This more than makes up for the loss of exemptions, since the phaseout for this credit was also dramatically increased. The phaseout was at $75,000 ($110,000 married) in 2017. Now it is at $200,000 ($400,000 married.) So lots of doctors that didn't get child tax credits in the past, now will. Unfortunately, it wasn't indexed to inflation. That's bad policy and has caused many issues in the past, particularly with the AMT.
There's a new “dependent credit” too. It's only $500, but it's better than a kick in the teeth. It includes your parents and college students.
Schedule A Changes
A lot fewer people will be itemizing in 2018. Part of that is due to the higher standard deduction. But another part is due to the fact that lots of Schedule A deductions were reduced or eliminated. Let's go through the major deductions there:
- Medical/Dental Expenses: No change (but few doctors could take this one anyway as it had a 10% of income floor). Actually, there was a slight change. It was decreased to 7.5%, but only for 2018.
- State Income Taxes: Combined with property taxes and limited to $10K. A dramatic decrease for most doctors.
- Property Taxes: Combined with state income taxes and limited to $10K. A decrease for some doctors in high tax states.
Sales Taxes: Gone completely. Some doctors in income tax-free states lose out here.- Mortgage Interest: Slightly limited. Instead of being able to deduct interest on up to $1M in mortgage debt, now you can only deduct up to $750,000. Old mortgages are grandfathered in. This will affect a few docs in high cost of living areas.
- Home Equity Loan Interest: Eliminated. No grandfathering.
- Charitable Donations: No real change. In fact, it gets slightly better as you can donate up to 60% of your income and deduct it instead of the previous 50%.
- Miscellaneous deductions: Severely limited or eliminated completely. This includes tax prep fees, advisory fees, trustee fees, unreimbursed employee expenses, and casualty losses among others. These were always subject to a 2% of income floor, so the truth is that few doctors had enough here to get a deduction. This is honestly good tax policy as it simplifies things quite a bit. Sorry if your pet deduction got euthanized.
AMT Will Hit Fewer Individuals
One of the biggest disappointments of this tax reform effort was that the AMT for individuals wasn't eliminated completely. Leaving it was a bad policy decision. It makes the tax code far more complicated. The good news is that it will hit fewer of you. The exemption amount was raised from $55,400 to $70,300 ($86,200 to $109,400 married) and more importantly, the phaseout of that exemption doesn't start until $500,000 ($1M married.) That number used to be $123,100 ($164,100 married.) Bottom line? If you have always paid AMT in the past, you very well may not in 2018, especially with your state income tax deduction so limited. Unfortunately, you (or more likely your tax software) will still have to run the numbers to know.
Bracket Changes
The most significant change that will affect everyone (and will likely lower the overall tax bill for most) is the change to the ordinary income tax brackets. Basically, your entire tax burden gets lowered by around 3% of your taxable income. Ignoring the political decision of whether the tax code should be more or less progressive, I was disappointed to see the five-bracket system originally proposed by the House plan be dropped from the final law. That would have been some serious tax reform and good policy. We still have seven brackets, but at least you'll pay less in taxes. Here's what they look like:
As you can see, what was 15% is now 12%, what was 25% is now 22% etc. The 35% bracket is now MUCH bigger. The overall effect is that marginal tax rates are lower for everyone except those in the 10% bracket. This is the main change that is going to result in most doctors and (most American taxpayers) paying less in tax. Anyone arguing against that point probably doesn't actually understand how taxes work.
Pease Phaseout Gone
Another benefit for well-paid doctors (and a good reform/simplification) is that Donald Pease will no longer be famous. The Pease phaseouts were basically a stealth 1% bracket that began at a taxable income of $261,500 ($313,800.) I hated this law, and not just because it raised my tax bill. It was poorly written as a phaseout of itemized deductions, when in reality it was just another tax bracket. If you want a more progressive tax code, just increase the tax rates. Don't make things complicated. Combined with the new top bracket, this basically reduced the federal tax rate on your 500,000th earned dollar for the year by 3.6%, from 41.5% to 37.9% (the 0.9% is the PPACA tax.)
Less Inflation Adjustment
Another minor change to the tax brackets is that they won't quite keep up with inflation. This bill changes the inflation measurement used to increase the brackets (and other tax policies) from “traditional CPI-U” to “chained CPI-U.” Economists argue about which is more accurate, but the new one is usually lower than the old one. That means a slight tax increase is now baked into the tax code every year.
Marriage Penalty Decreased
There is still a marriage penalty in that 35% bracket, but the overall effect of the marriage penalty is decreased. It maxes out now at $8K in taxes. That's good news for two physician families.
529 Account Changes
529 plans can now be used for K-12 expenses. That's good news for those of you with kids in private school. Now you can put the money in a 529 and pull it out the next day to pay high school tuition and maybe get a state income tax break on it. Not sure it will have a huge effect since most of those who can afford to put kids in private school were already getting the maximum 529 state income tax break as they saved for college. Note that there was originally talk of this including home-schooling expenses, but that was taken out in the end. Now there is one less reason to use a Coverdell ESA.
PPACA Taxes
There was no change to the 3.8% tax on investment income for high earners nor any change to the 0.9% tax on earned income for high earners. The penalty for not buying health insurance, however, is gone. You still need health insurance (and are technically still legally required to buy it) so this probably won't affect you much. There may be some less expensive (and less comprehensive) policies coming back on to the market though. I'm still wrapping my head around how this is going to change the health insurance and health care landscape in this country, but I think it will have a huge effect over the next few years.
Long-Term Capital Gains/Qualified Dividends
No significant changes here that are likely to affect readers of this site. There was some talk of some changes that would make tax-loss harvesting trickier, but those were not included in the final bill.
Estate Tax Exemption Amounts Doubled
The estate tax exemption amounts have been doubled. They are now $11 Million ($22 Million married.) Few doctors had to pay federal estate tax in the past, and it's even fewer now. It is still indexed to inflation (good policy.) Be aware your state exemption may be MUCH smaller than the federal exemption.
Alimony Tax Treatment Reversed
In what may be the worst possible policy change in the bill, those of you who pay alimony can no longer deduct the payment. Basically, now you pay for your ex-spouse's taxes on that alimony payment. In essence, it is a tax on divorce since that tax arbitrage (between the higher earning spouse and the lower earning spouse) no longer exists. One more reason to follow the One House, One Spouse rule. The only good news is that if you're already paying alimony, you're grandfathered in. Better not renegotiate that agreement though.
Deferred Compensation
There has been a bit of a crackdown on deferred compensation plans like 457(b)s. Expect to see a lot of changes here in the next year or two if you have one of these plans. The distribution options are going to become less attractive such that many doctors will opt to invest in taxable instead of using a 457, and might even regret using a 457 in the past. I'm still wrapping my head around what these changes are going to mean, but you may wish to put any 457 plan contributions off until the end of 2018 when things become more clear.
Loopholes
One person's pet deduction is another person's loophole. Here is a list of loopholes that made the cut and a list of those that did not:
Made the cut:
- Tax-credit for electric vehicle
- Schoolteacher deduction
- Elderly and dependent care credit
- Adoption assistance credit
- Increased business auto deduction (makes leasing less attractive)
Didn't make the cut:
- Moving expenses deduction
- Business entertainment expenses
This post is long enough, so I'll stop here. We've hit the high points and discussed how they will affect you. If you love reading about this stuff, you might want to check out what the rest of the WCI Network is saying about the tax plan:
PoF's Take: Tax Reform! How Physicians and Self-Employed Are Affected
PIMD's Take: How The New Tax Plan Affects the High-Income Physician
What questions do you have about the new tax laws? Comment below, but be aware we're not going to have a political discussion in the comments section of this post. You can go do that at Fox News or the New York Times if you want. It'll be deleted here.
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Lengthy, but solid post. Honestly, I think the two items of most interest to me that I feel are not so straight forward are the AMT portion (which I have written a post on), which has historically hit a lot of high-income earning physicians in the past, and the conversation on 457s.
My wife is a part time teacher and the only retirement option she has at the moment to take advantage of is her governmental-457. When she starts working full time I will switch her contributions over to her 403B/401K and leave the rest in her 457. I don’t participate in my hospital’s (non-governmental) 457 for a lot of reasons. Curious to know more on this, which you said will eventually come down the pipe.
Overall, most physicians are going to earn a tax break unless you pay a ridiculous amount of SALT that is now being lost due to the changes. Even those paying high SALT may end up ahead depending on how much they earn. The AMT alone has $109,000 exemption if making less than $1Mil and married. So, unless their SALT is higher than $109,000 they are likely earning a break or making even, though everyone’s tax situation is unique.
Thanks for the thought-inspiring post. Now to go learn more about the impact on the 457!
Thank you for such a coherent and thorough summary. It truly helps to have access to someone with your intelligence and diligence to help the rest of us out. I have been hearing about how different rules will be changing or phasing out over the next several years as well. Is that only talking about the tax brackets, and if so do you know what that timeline looks like?
There are some various phase-in and phase-out rules. Honestly though, I don’t pay too much attention to them. I find it kind of funny that people talk about what is “permanent” and what isn’t. There is nothing in the tax code which is permanent. But under the law, the individual tax bracket changes expire after 2025. Most of the changes start next week (so you’ll notice when you do 2018 taxes in Spring 2019.)
Jim, an excellent job on this-a real service to your readers!
One of the bigger impact we are seeing with our clients are charitable deduction limitations (or eliminations). Many of our older physician clients no longer have mortgages (something we work on constantly), so their Schedule A deductions will be primarily property/sales/state income tax (capped at 10K) and charitable deductions. Subsequently, any annual charitable donations less than 14K per year won’t be taken (they’ll take the standard deduction instead). As you note, we are setting up charitable gift funds to “bundle” multiple year charitable donations for these families.
For the “elderly” (perhaps, WCI’s parents?) meaning those who are over age 70 and 1/2, and who do like to give to charity; but, also, are likely to take the standard deduction rather than itemizing, one tax efficient manner for giving to charity would be to donate a portion or all of their RMD for their (pre tax) IRAs directly to charity……..rather than writing checks to charity.
Example: Married Couple over age 70 and 1/2 wishes to donate $10,000 to charity in 2018 and will be in a 12% marginal tax bracket. By donating the $10,000 to charity directly from their IRA, and still claiming the Standard Deduction, at least, this couple will save $1,200 in their 2018 Federal income taxes.
Can you link where you’re referencing the 457b changes? I max mine annually to reduce my AGI to lower my IBR payments (still fingers crossed for PSLF in 4 years). This could affect me quite a bit and I’d like to get to the original literature.
You want original literature? Here you go:
https://www.congress.gov/bill/115th-congress/house-bill/1
Good luck!
I think it’s under section 13603
Much appreciated.
Great now my brain hurts.
Would also like to have more details on this. I use a governmental 457(b) as I am an academic doc practicing in a state university hospital, and our plan representative has told us that nothing is changing with our plan as far as they can tell.
Good for you. Hopefully that is the case for all/most. But it is something to keep an eye on this year.
Same here. I also max 457 for same reason. I don’t plan to tap it until retirement. Where can we learn more about the changes?
Everything else I’ve read suggests our governmental and non-governmental 457(b) accounts are safe. My plan representative confirmed that based on their current understanding, there should be no changes to the rules governing the account, including payoff schedule and taxation.
Best,
-PoF
I’ve been reading….I am under the impression that 457 plans along with 403b plans were original targets of the Senate bill, and were subsequently removed. Did you see something different?
My understanding of the change is that when the money is vested, it is taxable and no longer deferred. How that ends up affecting 457 plans, I’m not certain (and I don’t know that anybody is.) But keep an eye on 457 plans to see how this law gets implemented. I think it might mean less attractive distribution options.
Currently a 457(f) is taxed in the account when that annual tranche is vested, but any gains thereafter are still deferred. This is a true deferred compensation; that is, employer contributes directly to the account. Very different from the 457(b). Not sure for anyone else, but my 457(b) is not subject to vesting since it only includes funds I contribute, plus gains of course. Neither of these are governmental, which have different rules.
Based on the below section, I don’t think medical professionals’ 457f comp will be affected:
“(3) REMUNERATION.—For purposes of this section:
“(A) IN GENERAL.—The term ‘remuneration’ means wages (as defined in section 3401(a)), except that such term shall not include any designated Roth contribution (as defined in section 402A(c)) and shall include amounts required to be included in gross income under section 457(f).
∫“(3) REMUNERATION.—For purposes of this section:
“(A) IN GENERAL.—The term ‘remuneration’ means wages (as defined in section 3401(a)), except that such term shall not include any designated Roth contribution (as defined in section 402A(c)) and shall include amounts required to be included in gross income under section 457(f).
“(B) EXCEPTION FOR REMUNERATION FOR MEDICAL SERVICES.—The term ‘remuneration’ shall not include the portion of any remuneration paid to a licensed medical professional (including a veterinarian) which is for the performance of medical or veterinary services by such professional.
For S Corp that only has enough income to pay small salary for per diem physician would pass thru entity deduction be 50% of salary or zero since 20% of $0 distributions is zero.
Whichever is less- 20% of taxable income or 50% of salaries paid. So in your example, I believe 50% of salaries paid.
Not for physician income. See: https://www.physicianonfire.com/tax-reform-physicians
I think POF disagrees that only the k-1 distributions would qualify for the deduction. He says:
“20% of your business income. If your service business is a side gig and your main job does not generate too much income to hit the limitation described above, this will be applicable to you. For those with service S Corps this includes dividends and wages”
The author of the guest post on the pass-thru deduction (https://www.physicianonfire.com/tax-reform-physicians/) sent me updates to that section last night. This is his interpretation:
It’s the least of the following 3 calculations:
1. 20% of your taxable income. If the majority of your income is from your business and you are not a dividend-heavy S Corp, this will be applicable to you.
2. 20% of your total business income. If your service business is a side gig and your main job does not generate too much income to hit the limitation described above, this will be applicable to you. For those with service S Corps this includes dividends and wages.
3. 50% of your nonservice S Corp W2. This does not apply to those with only doctor income. Those below the taxable income limit are exempted from this wages calculation and those above the taxable income are excluded from this deduction.
If you pay yourself less than 40% of your nonservice business profits (ie >60% dividends), this will be applicable to you. This is because 50% of W2 on 40% of all = 20% on all income (Calculation 1). As someone who lives in a state that adds an extra S Corp tax, it was not advantageous to use this to circumvent Medicare taxes.
For those doctors in a service S Corp, no changes will change their ability to get this Pass-Thru Deduction since this is based completely on the taxable income limit. I see this as guidance written into the code for those who use nonservice S Corps to be more reasonable. F
or those who are reading this and are not business owners, this W2 is not the same as the one you get from your employer and this article is not for you. For those pass-thru businesses with sizeable depreciable assets such as real estate or machinery, there is an alternate calculation of 25% of the W2 plus 2.5% of unadjusted basis that can be used if larger than 50% of the W2.
Ironically, those nonservice businesses without W2s or depreciable assets above the taxable income limit such as a married sole proprietorship with a taxable income >$415k would get no deduction and will likely be advised to setup an S Corp if the setup costs were less than the tax savings but I doubt few of these exist since the FICA exemption on the dividends should already make an S Corp useful.
You may be right. Great resource on this particular question here:
https://evergreensmallbusiness.com/pass-thru-income-deduction-dozen-things-every-business-owner-must-know/
The ebook he is selling is quite good as well. I haven’t made it through it all yet, but as noted in the post, there will be another post on this topic to come.
Definitely a confusing aspect of the new law.
The above article is correct but written in the same roundabout way the bill is plus does not mention you are also limted to 20% taxable income. His original overview of the bill didn’t explain it right and this corrected it.
Ive been holding out on contributing to my hospital’s 457b plan due to risks involved (exposing to employer’s creditors, distribution options,etc) but had recently been toying with the idea of contributing. Now with the new tax law I’ve been trying to do a lot of research on how the 457b will be effected, and whether I should still contribute to try and get below the new 315k limit /24% tax bracket for married couples filing jointly. Interested on more information regarding the 457b.
I’ve read a couple articles now that suggest the 457(b) is unchanged:
https://www.shrm.org/resourcesandtools/hr-topics/benefits/pages/how-tax-bill-alerts-employee-benefits.aspx
https://www.benefitnews.com/news/breaking-down-retirement-provisions-in-the-tax-reform-bill
There was some language in the Kitces’ article that sounded scary, but I found the same language in the bill under “Present Law” i.e. 2017 & before, on page 352 of the bill:
“Compensation is generally includible in an employee’s income when paid to the
employee. However, in the case of a nonqualified deferred compensation plan, unless the
arrangement either is exempt from or meets the requirements of section 409A, the amount of
deferred compensation is first includible in income for the taxable year when not subject to a
substantial risk of forfeiture (as defined), even if payment will not occur until a later year.”
So this language is nothing new, and I believe we’re OK, but if you’re at all uncomfortable, it wouldn’t hurt to hold off on contributing for a little while until it is confirmed that there are no changes impacting those of us who invest in governmental or non-governmental 457(b)s.
Glad to hear it. If I had one, I’d still keep an eye on it this year.
I believe both governmental and non-governmental 457(b) plans are exempt from 409A requirements. Therefore, 457(b) participants can ignore everything beyond that point in your quote above (specifically, the scary line about deferred compensation being includible in income for the tax year when it becomes vested).
It is spelled out here:
“Although Section 409A covers a broad array of arrangements, it does not apply to tax-qualified retirement plans (e.g., 401(k) plans), 403(b) plans, 457(b) plans, or similar tax-favored plans, even though these plans also delay taxation on the compensation deferred thereunder.”
http://www.wagnerlawgroup.com/pdf/taxation-of-deferred-compensation.pdf
Cool. Glad to hear it.
for whatever this is worth my benefits guy at my shop, which offers a non-gov 457b, seems to think they are unaffected
I’m hearing that a lot now. Maybe I was making much ado about nothing.
I’m a little confused still about the pass through deduction and how it may/may not affect me. I have been doing consulting the last few years and have been taxed as a sole proprietor. I had run the numbers a few times and it didn’t really make much sense in my situation to become an S-corp. Next year, my Gross receipts will likely range between $350-$380,000, with net profit being in the range of $340-$370,000. Since I do not pay myself a salary (yet) that number would go on line 12 of 1040 as business income. From your summary, I think I might be getting a pretty nice deduction but I’m worried about the limits to income. Is limit to the income numbers you mention from the profit of the business, or the total taxable income of the individual? In other words, are the numbers you quote from line 31 of Schedule C (line 12 in 1040), or line 43 of form 1040? Because I max out my individual 401k at $54,000, HSA at $6,750, SE tax deduction, etc, my “taxable income” will be well under the $315,000 threshold. So would I still get a 20% deduction on the net profit from the business, or do I need to incorporate into an S-corp, and pay myself 1/3 of the profit as salary to get the net profit under $315k? Sorry for the long post, but this is by far the best explanation of the deduction I’ve seen so far, but I’m still a little confused how it’s actually determined.
I should mention I am married and my wife does not currently work.
Join the club, we’re all still a little confused about it. But the good news is you don’t have to DO anything about it. You just calculate it in April 2019 and you get what you get. I think it’ll be more clear when we see the worksheet the IRS puts out about calculating it.
I hope someone else can come along and give you a definitive answer to your question.
I guess that’s not entirely true. One thing that could be done is change how much you pay yourself in salary. I suppose if the 50% of salary limit is the limit affecting you, then you could increase salary.
Yeah that’s kind of what I was getting it, I don’t currently pay myself any salary, it’s all just business income. But if paying myself $100,000 in salary (reasonable for my profession) would mean a $40,000 deduction (20% of $200k+) I may have to do just that. It would change the equation a little and make incorporating more worth while. Like you said though, just need to see the IRS worksheet to figure it all out. Is there a general time frame for how long worksheets take when new tax laws take effect? Would it be sometime in early 2018, or more likely toward the end. I know that’s a question that might not have an answer.
Don’t know that one either. I’m planning on reading Stephen Nelson’s new ebook soon and before I do a whole post on this topic, but haven’t gotten around to it yet. I’d suggest that if you prefer not to wait before figuring this one out.
Thanks for your quick replies and great content on all of this. I’ve been reading the lengthy forum post this site has going on the topic and think I have a better understanding now. Posting in case others want to view. https://www.whitecoatinvestor.com/forums/topic/pass-thru-deduction-explained/page/9/
Thanks for following along but I think WCI might be off on this. See the new SCorp interpretation where I point the lines of the bill that basically exclude service industries from needing the 50% w2 calculation.
Wouldn’t be surprised if I’m off given the lack of clarity from the IRS on this topic. It would make a good post once they publish their worksheet for this deduction.
I see what you’re referring to in the post. I made a couple of changes there.
Here’s my understanding as it applies assuming an S Corp entity, DP:
S Corp ordinary business income, as reported on your K-1 Line #1, pass-through to your personal tax returns and reported on line #17. As you correctly stated, HSAs, and either your standard or itemized deduction, are subtracted out. But, not SE tax nor retirement contributions as they have been subtracted from S Corp net business income. This amount is subtract from your aggregate income which includes your W2 wages (line #7) plus S Corp business income (line #17) plus any other income. If your taxable income is )
TAXABLE INCOME = $287,600
Your taxable income is <$315k, therefore eligible for the full 20% QBID. The QBID is the lesser of taxable income ($287,600) or S Corp Business Income ($236,350) x 20%. So, $236,350 x 20% = $47,270. $47,270 is the amount you can exclude from taxable income resulting net tax saving of $11,344.80 (using a 24% marginal tax rate).
Now, sole proprietor vs S Corp is another discussion. If reasonable compensation is $100k with S Corp, there may be some SE tax savings.
Edit:
Here’s my understanding as it applies assuming an S Corp entity, DP:
S Corp ordinary business income, as reported on your K-1 Line #1, pass-through to your personal tax returns and reported on line #17. As you correctly stated, HSAs, and either your standard or itemized deduction, are subtracted out. But, not SE tax nor retirement contributions as they have been subtracted from S Corp net business income. This amount is subtract from your aggregate income which includes your W2 wages (line #7) plus S Corp business income (line #17) plus any other income. If your taxable income is <$315k as married, you should qualify for the QBID. Calculating the QBID - 20% the lesser of taxable income or your line #17 (or S Corp business income). I suspected the lesser of will be, in most S Corp cases, your S Corp business income. Gross Income = $380,000 Less: W2 compensation = $100,000 Less: Payroll taxes = $7,650 Less: Employer Retirement contribution = $36,000 Equals = $236,350 S Corp Business Income Personal Tax Returns: W2 Compensation = $82,000 ($100,000 - $18,000 employee retirement contributions) S Corp Business Income = $236,350 Total Income = $318,350 Less: HSA of $6,750 Less: Standard Deduction $24,000 (Assumption, but Itemized deduction could be >)
TAXABLE INCOME = $287,600
Your taxable income is <$315k, therefore eligible for the full 20% QBID. The QBID is the lesser of taxable income ($287,600) or S Corp Business Income ($236,350) x 20%. So, $236,350 x 20% = $47,270. $47,270 is the amount you can exclude from taxable income resulting net tax saving of $11,344.80 (using a 24% marginal tax rate). Now, sole proprietor vs S Corp is another discussion. If reasonable compensation is $100k with the S Corp, there may be some SE tax savings.
Point of clarification
The totals people mention as limits – is that from all income or only income derived from the LLC?
I have a few LLCs and my main job at an AMC. Total income – gross and net will be higher than the ~400k mentioned as a limit, butmy LLCs make 100-200k/year.
Thanks for clarifying
Great summary. The AMT has always been a convoluted mystery to me. We will see if I am hit with it this year. As for the rest, I will likely take standard deductions except for years I bundle charity.
You’ll be less likely to hit AMT this year!
It’s amazing how many docs are taking the standard deduction in 2018, including yours truly.
Married brackets:
10% to 19050 is $1905
12% to $77,400 is $7002
22% to $165,000 is $19272
24% to $315,000 is $36000
32% to $400,000 is $27,200 (above 400,000 AGI does not apply to me).
And for those that break $400,000, (some docs do) add 35% of all $400,000 to $600,000.
That’s $91,379 in federal taxes by $400,000 AGI
The calculator I used put in the new standard $24,000 AND added in $10,000 for SALT/mortgage interest and then took off $6000 in child credits? Is that correct? can’t tell if it helps me or hurts me even with the darn calculators. Still too complicated.
Anyone find a good 2018 tax calculator? I have W2 income, self employed income, three kids at home, and max out my 401K ($24,000) and SEP ($30,000). We will all be capped at $10,000 for SALT/mortgage interest/property taxes, right?
I’ll read the article again…
Are you applying brackets to AGI instead of taxable income? Remember tax is calculated off taxable income. And beware the calculators out there. I’ve seen some terrible ones in the last month.
I think I am getting these mixed up. Taxable income is
I make ~ $300K W2 income. I also make $170K SE income.
On the W2 income, $24K comes off the top (401K). On the SE income, expenses come off (say 10K) and max SEP comes off the top.
So (300K – $24K 401K) + ($170K – SEP 30K – 10K expenses) = 406,000.
Take the child credit $2000 per kid X 3 and also the max SALT/mortgage int./prop taxes of $10,000 and you get $406,000 – $16,000 = $390,000 taxable income?
Gross income
Adjusted gross income
Taxable income
in order of decreasing size. SEP is taken out between gross income and adjusted gross income. Standard deduction or itemized deductions like SALT/mortgage interest/property taxes come out between AGI and taxable income. Tax is calculated on taxable income. Then credits are applied.
So start with $470K. Subtract out $55K.
$415K AGI
Subtract out EITHER $24K standard deduction OR itemized deductions. Let’s assume standard, which leaves you a taxable income of $391K. You won’t get the entire child tax credit though as it starts to phase out at an AGI of $400K, but you should get most of it.
Thanks. I learn new things weekly on your site.
According to my rough calculations solely based on the tax brackets, the biggest tax differences will be see between taxable incomes of $150,000 and $200,000. Those with a taxable income $200,000 will see about a $14,000 reduction in taxes. The reduction appears to remain approximately the same as income increases up to $500,000. That’s more than enough to fund a personal and spousal backdoor Roth IRA for anyone not already doing so.
Great post Jim. I guess time will tell as to the best way to shift tax strategies. Thanks again!
I am semi-retired my practice files a schedule C. I really have no salary just what is left over after expenses. Filing single. My practice income since quitting OB ranges 60-90k. I have so far this year made 163K in dividends and capital gains. Will this income be counted toward the 20% deduction? I am afraid I know the answer. Will roth conversion income count as well? Any idea on Muni bond interest? Thanks.
The dividends and capital gains and muni bond interest and Roth conversion income won’t count toward the 20% number, because that number is based on self-employment income. But it may make you unable to take the pass thru income deduction due to your now higher income.
Like I told the other poster above, it’s really hard to sort out until the IRS shows us the worksheet we’ll be using to calculate it.
Thanks. It is confusing. My initial understanding was this “other” income eliminated this deduction for me.
My understanding, is that step #1 to determining your pass through deduction is determining your taxable income. Dividends, capital gains, etc appear to be included. So you would be >157.5k single filer. Because your pass thru income is from doctoring, there will be a 1%/1k phaseout. So if total income is 220k, phaseout is 62.5%. If you are paid as sole propietor, the total income=income eligible for the deduction. If S corp, only dividends not W2 compensation. The deduction is applied to the lesser of taxable income or business income. So for you it’s 60k x (1-.625) x 0.2=4500 deduction.
I believe the last example in this article answers your question.
https://www.forbes.com/sites/anthonynitti/2017/12/26/tax-geek-tuesday-making-sense-of-the-new-20-qualified-business-income-deduction/#15ddb8d644fd
Nicely written for a complex topic
So as POF mentioned above, I believe you have the Pass Thru Deduction (Qualified Business Deduction) wrong. I didn’t rely on other write-ups. Reading the bill takes some time. See my post with POF (the only changes I made was with S Corps which I originally breezed over since it is not applicable to me). It’s actually limited by WAGES not dividends. The thing is the wages limitation does not apply for those under the taxable income limit ($315k MFJ phased out up to $415k). I point line by line on your forum of how I came to such conclusions.
The thing I learned from you: removal of state sales tax deduction. Hurts me but I like simplifying for the sake of our country.
Actually what I’ve read in other sources (I’ll check the bill later … starting to trust no one) the sales tax deduction was not eliminated but placed under the $10k limit with the other state taxes: income and property.
Yes I read your posts. Excellent. I think you are saying I qualify for QBI on my med practice filed on schedule C even if cap gains, dividends, interest, and roth conversion income would be above the cap. So income for the deduction is only “work” income not other sources?
If on the 1040 you get to >415k mfj or >207.5k single on the taxable income line (after all other adjustments/deductions) you do not get this deduction. If you are below that limit the calculation is lesser of 20% business income (likely if side gig) or 20% taxable income (likely if main income).
Thanks.
I agree this is one of the trickiest parts for us all to understand and one of the most important to understand. Which is why I plan another post on it. But as I understand it, it can be limited either by total pass-thru income or wages. I’m really looking forward to seeing the IRS guidance on this one. The only question I have to wrestle with is how much salary WCI should pay us, and I have months before that decision has to be made. Other than that, it’s just a matter of how large the deduction will be.
As long as your wages are 40% of the net profit (<60% dividends), you should get a full 20% of the business income. Otherwise its 50% of your wages. Note: this for your NONservice industry (blogging/book) and not for most of your readers. The wages limitation is not applicable to those with taxable income above certain limits ($315k MFJ) and those with service businesses above the phaseout ($415k MFJ) get no deduction.
Great post. Thank you. One correction: PPACA was also ultimately passed through budget reconciliation. Pretty sure that’s where the idea to use reconcialition originated.
At the risk of delving very briefly into politics, reconciliation has been used since the 1980s for various things. More discussion of just how PPACA passed can be found here: http://www.briansussman.com/politics/how-obamacare-became-law/ and yes, it involved reconciliation thanks to the election of Scott Brown after Kennedy died.
True. Also at the risk of being too political, the repeal of the individual mandate in the bill could also have long-term implications on physicians.
Absolutely. Hard to tell what they will be. Feel free to start a discussion in the lounge on the forum about it.
i mean it will certainly have some implication but i don’t think MD life changed much pre-individual mandate and post.
the medicaid expansion seemed to have far more bearing on the day to day life of docs IMHO.
Thank you for a very nice explanation. IMO AMT is so poorly understood by many, including many physicians. I’m confused on any given day. Lots of people hand over their taxes to a CPA and don’t even realized they pay AMT meanwhile thinking they reap the benefits of all their deductions. Or they look at the 1040 line 45 and see something like AMT 3K and think that was the calculated tentative AMT rather than being the difference between the two parallel taxes. They also see the exemption phase out as the income where AMT doesn’t apply, which is not the case necessarily. The only way to know if one will be hit with AMT in 2018 for sure is to calculate it. With the changes yes the likelihood is fewer will see a number on line 45, or at best will be smaller than years previous. we haven’t paid AMT in years…..which just means the government is pleased that we are paying enough taxes already…….which was the intention of enacting the AMT to ensure people were not deducting away their entire tax liability…..
Do mean to nit pick (huge fan really) but I think you meant: More will NOT itemize. Small typo, right?
Do *NOT* mean to nit pick. Oh the irony… I blame autocorrect.
i caught that mistake too.
Under heading: Higher Standard Deduction (paragraph)
“More people will itemize and not have to track all the Schedule A (itemized) deductions. ”
I also think it is suppose to say NOT itemize
Thank you for the correction.
Thanks for this info and for all you do. Regarding the pass throughs…the way I am understanding is that as long as your not paid W2 (employee), you would be eligible for the deductions. That holds true whether or not your sole proprietor, self incorporated S Corp, LLC or otherwise.
For example I’m part of a large partnership paid via K1 (CEP America). I pay self employement portion of payroll tax, etc…I have not formed an S Corp mostly due to the limited benefits as outlined in some of your previous posts. However there are several partners, including some in our local group who have incorporated who then contract their S Corp or LLC with the parent partnership.
It seems like as things stand currently I should still qualify for the pass through deduction as a “sole proprietor” paid via K1 without incorporating. However if not it certainly seems as though the incentive to incorporate is now significant with the tax savings implications. Am I correct in this?
Yes as long as your taxable income is under the limit. See https://www.physicianonfire.com/tax-reform-physicians
No need to change as far as I can see.
If you are a W-2 employee today, participating in a private practice, who can expect to earn ~$300-$400K in W2 wages w/ a profit sharing 401k of rougly $55k a year in benefit, do you have an opinion on if there is a better way to structure yourself going forward? Perhaps as an LLC? I do not want to start my own practice, but want to ‘consult’, etc. if possible and there is possibility of benefting from the tax changes. Any ideas?
Sure, there are lots of benefits to being an independent contractor, but there are downsides too. It may be that under this new law that the benefits just got bigger. I think we’re all trying to sort that out right now.
Forming the LLC doesn’t add anything though.
Thank you kindly for the reply.
Fair enough on the LLC point! Will be watching and hope to gain your thoughts in the days ahead as I try to understand how much more “worth it” it could be going forward. I wonder how much this will change compensation planning and contracting, overall, in the years ahead.
Thanks again!
Many thanks for posting this very clear and comprehensive article on the new tax law!
Bad news: I fall into a higher tax bracket now. Good news: I won’t be hit by AMT. Seems a very fair trade to me! I’d much rather deal with higher tax brackets than with having to calculate my taxes twice!
I don’t know if I’m still going to be itemizing or not, but since I don’t make my charitable contributions solely to itemize them, i really am not too worried if I lose them as a deduction.
I’m going to continue to contribute to my hospital’s non-governmental 457(b) for now, but I’m also going to keep a close eye on it for the next year or two. I’ve already got enough in there that it might be wise to switch future contributions over to a taxable account in any case, regardless of how the tax issues shake out, just to avoid excessively high RMDs in the future (since my hospital doesn’t offer a Roth 403(b) option and you can only backdoor so much).
Even if your bracket/marginal rate is slightly higher (and there is a very limited range where that is the case), the lower brackets are now at a lower rate, so your overall effective rate should still be lower, at least until you lose the state income tax deduction.
Thanks so much for the thorough post! Especially appreciate the heads up about possible 457 changes. Quick question about backdoor Roth–my understanding is that the new law doesn’t affect ability to contribute to a nondeductible tIRA and then convert to Roth (but that it does do away with recharacterization if you were to later change your mind), so that the backdoor Roth is still available in 2018 and going forward. Is that your understanding as well?
Yes. No changes to backdoor Roth, PPACA taxes for high earners, or capital gains/qualified dividends related taxes.
This is probably a stupid question but here goes. I don’t do my own taxes so I will ask. Can I take the standard deduction and file a schedule C?
Yes.
Yeah from what I’ve gathered schedule A might become rarer than a schedule C!
Good news for me. I think.
Would love to see post on 457b when new rules about these plans become more clear later next year. Without the $18000 tax deferred into a 457b and since I have a 403b at my main job, I’ll have to figure out how to make about a $100k on my 1099 side gig to get a similar amount of tax deferred income (given rules for interaction of solo 401k and 403b). It was already a pain making $45k this year on my 1099 side gig so I may just opt for a taxable account if the rules for 457b change in a unfavorable way rather than struggling to make more money on the 1099.
Our county govt doesn’t bill for property taxes early and wouldn’t accept payments early so I wasn’t able to prepay 2018 property taxes. That was pretty annoying. So I used the money I planned to use for paying property taxes to pay-off the remainder of a car loan (1.99%) bought before I knew about your financial philosophy. That got rid of my last piece of non-mortgage (remainder of student loans paid off earlier this year) aside from a home mortgage. Getting rid of the debt made me feel better about things.
Sounds like there may not be much of a change there, but stay tuned and watch for literature from your employer about it.
The good news for you is that the IRS clarified that 2018 property tax payments made in 2017 wouldn’t be deductible unless you had an assessment done in 2017. So all that trouble a lot of us went through to prepay ours was for nothing. Good job paying off your debt.
Thank you for the detailed report and in-depth analysis. Just like you mentioned, i am like most of the American public who believes the tax cut benefits the big corporations with little benefit (and possible harm) to me as a physician living in California (high COLA). I blame the mainstream media for this. Thank you for doing the leg work for the rest of us and inspiring me to learn more about the tax bill and how it truly affects us.
For sure it benefits the “big corporations” (like the ones you own in your 401(k) and Roth IRA) and for sure it hurts a doc in California more than a doc with the same income in Nevada. Whether or not YOUR taxes go up or not comes down to the details, but for most it will not, at least not before 2025.
Thank you for realizing the error of your original thinking [political comment deleted] and thank you, WCI, for combating it. Tax law changes neither hurt nor benefit “big corporations” because corporations don’t actually pay taxes at all, [political comment deleted] a corporation, big or small, is NOT a person; a corporation is a only legal structure. ALL so-called “corporate taxes” are ultimately paid by the shareholders (in the form of reduced dividends/cap gains) and customers (higher prices) of the company–i.e., the general public who owns shares and buys goods/services.
If you truly wanted to “soak the rich”, corporate taxation is a very poor and convoluted way to do it. It would be way more direct and effective to simply crank up the highest personal rates instead.