Tax Reform Law: 7 Ways It Affects Your Personal Finances

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 7 Ways It Affects Your Personal Finances

New legislation known as the Tax Cuts and Jobs Act became law on December 22, 2017. Starting in 2018, it affects virtually every U.S. taxpayer with dramatic changes including new tax rates, fewer deductible expenses, and a major modification to healthcare.

I’ll cover seven of the main ways tax reform affects your personal finances. Understanding these changes now can help you prepare, avoid potential pitfalls, and keep your tax liability as low as possible.

7 Ways Tax Reform Affects Your Personal Finances

  1. Income tax brackets and tax rates change. 
  2. The standard tax deduction increases. 
  3. The personal and dependent tax exemptions are eliminated. 
  4. Homeownership benefits are reduced. 
  5. State and local tax breaks are limited. 
  6. Education incentives are modified. 
  7. Healthcare mandate penalty is eliminated.

Here’s more detail about how tax reform changes your personal finances.

1. Income tax brackets and tax rates change.

The Tax Cuts and Jobs Act keeps the basic structure of our progressive income tax system but modifies the brackets and rates. Don’t worry, I’ll explain this tax jargon in plain English.

Having a progressive income tax system means that higher amounts of income are taxed at higher rates. Previously, we had seven brackets or tiers of rates: 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.

Progressive taxation means that you aren’t taxed at one rate (unless your income is solely in the bottom bracket), but have multiple tax rates applied to your income. For example, under the old system, if you were single and made $60,000, you’d pay three different tax rates:

  • The first $9,525 of income was taxed at 10% 
  • The next $29,175 was taxed at 15%, accounting for a total of $38,700 
  • The last $21,300 was taxed at 25%, accounting for the full $60,000

Even though it would be common to say you’re in the 25% tax bracket under this scenario because that’s where your income tops out, you don’t pay 25% on all your income.

Many taxpayers will benefit from the Tax Cuts and Jobs Act, but some high earners will pay more tax.

Under the new law, we have the same number of tax brackets, but the rates assigned to five of the seven tiers are slightly lower: 10%, 12% 22%, 24%, 32%, 35%, and 37%. And the range of income assigned to some of the brackets has changed.

For example, under the old system, a single taxpayer with $40,000 of taxable income topped out in the 25% tax bracket and would pay about $5,700 in taxes. Under the new system, that person would be in the 22% bracket and pay about $4,700, or $1,000 less.

Many taxpayers will benefit from the Tax Cuts and Jobs Act, but some high earners will pay more tax.

The IRS just released new tax withholding guidelines to employers so they can modify paychecks no later than February 15, 2018. So, if you’re an employee, you should see a slight increase in your take home pay by then.

It’s a good idea to review changes in your tax withholding carefully because if too little is taken out, you could end up having to pay more at tax time. And given all the new tax changes happening, which I’ll cover here, I recommend that you review your withholding anyway because you may not get as many allowances on your W-4.

2. The standard tax deduction increases.

The new tax law increases the standard deduction by a significant amount. Before I give you the numbers, here’s a primer: Deductions allow you to subtract certain expenses from your taxable income, which reduces your tax bill.

But even if you don’t have any deductible expenses, our tax system throws you a bone just for breathing! It’s called the standard deduction. You can claim a standard flat amount for your filing status (such as single or married), with no questions asked.

You have another option called itemizing deductions. This means you add up all your deductible expenses and list them on your tax form. Itemizing saves money when the total exceeds your standard deduction, but it’s more of a hassle because you have to prove your expenses are legit.

You can never claim both the standard deduction and itemize deductions in the same year. But you can alternate methods from year to year, depending on which option saves the most. So, it’s wise to run the numbers both ways every year to see which option gives you a bigger deduction.

There are some situations when you can’t claim the standard deduction. One is if you’re married, but file taxes separately, and your spouse itemizes deductions. In that case, you both must itemize.

You can never claim both the standard deduction and itemize deductions in the same year. But you can alternate methods from year to year, depending on which option saves the most.

Here are the new standard deductions under the Tax Cuts and Jobs Act by tax filing status:

  • Single: Increases to $12,000 from $6,500
  • Head of Household: Increases to $18,000 from $9,550
  • Married filing joint taxes: Increases to $24,000 from $13,000

As you might imagine, these higher standard deductions make it more likely that fewer Americans will want to itemize. It’s still a good idea to continue tracking your deductible expenses so you can make the comparison; however, there are many fewer deductions now. I’ll tell you more about what’s changed in a moment.

3. The personal and dependent tax exemptions are eliminated.

Another tax term you hear a lot is the personal exemption. It's been eliminated under the Tax Cuts and Jobs Act, but I’ll give you a quick explainer.

The personal and dependent exemption was simply an amount that you got to deduct from your income for yourself and every dependent you claimed on your tax return. It was another deduction just for being alive, in addition to your standard or itemized deductions.

Prior to 2018, the exemption reduced your taxable income by $4,050 per person, up to certain income limits. But you probably won’t miss it now that there’s a much higher standard deduction.

4. Homeownership benefits are reduced.

You might be glad to hear that the mortgage interest deduction isn’t going away; however, it has been reduced for new loans.

I mentioned that for many people, taking the standard deduction (instead of itemizing) may be more attractive because it will be larger starting in 2018. Plus, many itemized deductions are getting reduced or eliminated.

The home mortgage interest deduction is one of the most popular itemized deductions because it can be large, and therefore cut taxes significantly. If you're a homeowner or want to be one someday, you might be glad to hear that the mortgage interest deduction isn’t going away. However, it has been reduced for new loans:

  • Interest on a new mortgage is limited to interest paid on a maximum of $750,000, or $375,000 if you’re married and file taxes separately. That’s down from $1 million, or $500,000 if filing separately. 
  • Interest on a home equity loan or a home equity line of credit (HELOC) is no longer deductible. You used to have up to $100,000 of interest paid on home-related debt that was deductible.

Another big homeownership benefit that’s been scaled back is the exclusion of gain from the sale of a principal residence. This regulation allows you to skip paying taxes on a huge chunk of money you might make when selling a home.

The major requirement to be eligible for this tax break is how long you've lived in the home. It used to be a minimum of two of the previous five years before you sell the home. Now you must live in the home for a longer period to qualify, for at least five of the previous eight years.

In addition, this benefit gets phased out or reduced when you earn more than $250,000, or $500,000 when filing a joint return. High earners and those who own higher priced homes are affected by these tax changes the most.