[AUDIO INTRODUCTION] Welcome to the Bryn Mawr Trust Wealth Management podcast, providing commentary on what’s moving the financial markets, financial planning, and other timely business and monetary topics. Please welcome your host, Jennifer Fox, president of BMT Wealth Management.
[SPEAKER: JEN FOX] Hello, everyone. This is the second in a series of podcast providing coverage on the 2017 Tax Cut and Jobs Act. Today’s topics include the alternative minimum tax, the estate tax, and the kiddie tax, otherwise, known as the tax on unearned income of dependents. Please welcome Paul Gaudio, a wealth planner with BMT Wealth Management.
[SPEAKER: PAUL GAUDIO] Thanks Jen.
[SPEAKER: JEN FOX] Paul, I understand that as with all provisions of the Tax Cuts and Jobs Act relating to individuals, the new law will sunset at the end of 2025 and revert to the laws that were in effect on December 31, 2017. I’m assuming that that probably makes a difference with respect to financial planning.
[SPEAKER: PAUL GAUDIO] It sure does.
[SPEAKER: JEN FOX] So with that, why don’t we start with the changes in the alternative minimum tax or AMT. So have the Tax Cut and Jobs Act impact AMT?
[SPEAKER: PAUL GAUDIO] Well, let me begin with some history and put things in perspective. The alternative minimum tax was introduced in 1969. And it was initially targeting fewer than 200 high income taxpayers who were able to significantly reduce or eliminate their federal income tax.
Since its enactment 49 years ago, the provisions governing the tax have been modified many times. And an ever-increasing number of taxpayers have been ensnarled in the AMT trap. In 2017, the AMT raised an additional $38 billion in revenue for millions of taxpayers.
Essentially, it’s a parallel tax system that in AMT parlance makes adjustments in preferences to items of income and deduction that are treated differently compared to the regular tax system. The starting number to use to calculate the AMT tax is the taxable income figure for regular tax purposes.
From there, positive and negative adjustments are made. For taxpayers that find themselves paying it, an AMT tax, the most common reason is the elimination of deductions for real estate taxes, miscellaneous, itemized deductions, and state income taxes.
[SPEAKER: JEN FOX] So Paul, with that, are there exemptions built into the AMT system?
[SPEAKER: PAUL GAUDIO] Yes, similar to the standard deduction for regular tax purposes, the AMT provides taxpayers an exemption from the tax. You won’t have an AMT tax liability if your alternative minimum taxable income is less than $109,400 for married filing jointly, and $70,300 for single filers.
The Tax Cuts and Jobs Act of 2017 made a 30% increase to the exemption from the prior year. And those aforementioned figures reflect that increase. The most significant change, however, was the increase in the threshold before the AMT exemption is reduced were commonly referred to as phased out.
Previously for married filing jointly tax payers, for every dollar in excess of $160,900, the exemption was reduced by $0.25. And for single tax payers, for every dollar in excess of $120,700, the exemption was reduced by a similar amount. Those thresholds are now $1 million for married, filing jointly, and $500,000 for single filers.
[SPEAKER: JEN FOX] So it sounds like the good news is that that’s a significant increase in the threshold. But how many AMT tax rates are there?
[SPEAKER: PAUL GAUDIO] There are only two tax rates for purposes of the alternative minimum tax– 26% and 28%. For all tax payers, except those married filing separately, AMT income below $191,500 is taxed at 26%. And anything above that is taxed at 28%. The reduced rate for qualified dividends and long-term capital gain is the same for purposes of the AMT.
[SPEAKER: JEN FOX] I see. So will most tax payers be subject to the alternative minimum tax?
[SPEAKER: PAUL GAUDIO] The good news is no, given the $10,000 cap on deducting state income tax and property tax, as well as the elimination of miscellaneous itemized deductions and personal independency exemptions unlike previous years, most taxpayers will not find themselves in the AMT trap.
The bad news is that although you would think the elimination of or reduction in the AMT tax would be a positive thing, for many, it will simply mean a higher regular income tax. As an aside, the alternative minimum tax for corporations was eliminated.
[SPEAKER: JEN FOX] Interesting. So let’s shift to changes in the estate tax exemptions. Should people be taking advantage of the increase in estate tax exemptions, especially given the potentially short-term time horizon?
[SPEAKER: PAUL GAUDIO] I would say yes. Exploring the alternatives with your professional advisors prior to the expiration of the current law at the end of 2025 would be a prudent thing to do. As you may know, the estate gift and generation-skipping transfer tax have been unified since 2012. That means the exemption and tax rates for all three taxes are the same.
The exemption per taxpayer was doubled to $11,180,000 in 2018. Effectively, married couples can now shield up to $22,360,000 before any tax would apply. Within the estate tax regime, there has been an increased focus on income tax planning, meaning how can the estate tax be minimized while maximizing the basis adjustment upon debt?
[SPEAKER: JEN FOX] So Paul, historically, in doing estate planning, haven’t formulated clauses been utilized in estate planning documents, which were predicated on federal or state estate tax exemptions?
[SPEAKER: PAUL GAUDIO] You’re absolutely right. Formula clauses have been used in estate planning documents. And given the changes at the federal level, as well as significant changes at the state level, these formula clauses may lead to unintended consequences.
For example, many state documents provide that at the death of the first spouse, an amount that can pass free of federal estate tax, $11,180,000 in 2018 will pass to a trust for the benefit of the surviving spouse. For many people, that means the surviving spouse will receive nothing outright.
For others, the opportunity cost may come in the form of a higher income tax liability for the remainder beneficiaries of the trust, as those assets will not be included in the survivor’s estate and hence, will not receive a step up in basis.
[SPEAKER: JEN FOX] So how are things different for residents of different states?
[SPEAKER: PAUL GAUDIO] Yes, they are. For New York residents, for example, fully funding the federal exemption at the passing of the first spouse could result in a state estate tax approximating $1.3 million.
Residents of New Jersey have seen the state to estate tax exemption increase from $675,000 to $2 million in 2017, and its complete elimination in 2018. Many residents, particularly, those under the federal estate tax exemption, use the formula clause based on the state estate tax exemption.
We all know what the number zero does in a multiplication formula. Pennsylvania imposes an inheritance tax of 4 and 1/2%, 12%, or 15%, depending on the relationship to the decedent. For lineal descendants– children, grandchildren, parents, grandparents– the tax rate is 4 and 1/2%.
For siblings, it’s 12% and transfers to all other persons or taxed at 15%.
[SPEAKER: JEN FOX] So what can taxpayers do now to take advantage of the current estate tax exemptions, which are at a pretty exceptionally high level?
[SPEAKER: PAUL GAUDIO] They can do several things. The taxpayer can establish a trust. They can complete a gift for transfer tax purposes and remain a potential beneficiary as to income and principal of the trust at the discretion of an independent trustee, thereby, taking advantage of the current exemption.
Although the assets are removed from the donor’s estate, the assets transferred to the trust will retain the cost basis of the donor. A potential tradeoff between estate tax and income tax. There are lots of variables and factors to consider. And exploring the alternatives before the current law expires would be prudent.
[SPEAKER: JEN FOX] So Paul, that’s good advice. And I think it’s an exceptionally good reminder of how important it is to regularly meet with your advisors, especially, after such major changes in the tax law. So as we’re moving onto the third topic for today, and on the impact taxes have on the younger generation, can you help our listeners better understand the rules surrounding the kiddie tax?
[SPEAKER: PAUL GAUDIO] Of course. The proverbial kiddie tax is a tax imposed on dependent children who are under the age of 19 or under the age of 24 if they are a full-time college student, and who are fortunate enough to have a relatively high amount of unearned income in the form of interest dividends and capital gain.
The kiddie tax rules were enacted to mitigate the shifting of income tax liability from a parent’s high tax rate to the low tax rate of the child. Prior to the enactment of the Tax Cuts and Jobs Act, unearned income of a dependent of more than a statutory amount was taxed as if included in the parent’s income.
[SPEAKER: JEN FOX] So what change with the passage of the new tax law?
[SPEAKER: PAUL GAUDIO] Beginning on January 1, 2018, unearned income of a dependent child above $2,100 will be taxed based on the tax rates attributable to trusts and estates. Given the limited and compressed tax rates for trust and estates, there are only foreign tax rates– 10%, 24%, 35%, and 37%. And the top rate applies to taxable income over $12,500.
The new legislation will likely cause a shift in investment strategy in a more careful selection of securities being transferred into the name of a dependent child. For example, municipal bonds and many government bonds are highly tax advantaged.
The so-called FANG stocks– Facebook, Apple, Amazon, Netflix, Google, or other growth-oriented stocks, many of which don’t pay a dividend, would be good securities to transfer to a dependent child. Qualified dividends in long-term capital gain of a dependent child up to $4,650– the upper limit of the 10% tax bracket will be subject to a zero tax rate. That’s a potential savings of almost $1,000 if the parents are in the highest marginal tax bracket.
[SPEAKER: JEN FOX] That’s quite a lot to digest and very informative. Thank you so much for joining us, Paul. We look forward to presenting more tax podcasts in the future.
[SPEAKER: PAUL GAUDIO] Thanks, Jen. It has been a pleasure.
[AUDIO CONCLUSION/CLOSE] This has been a production of Bryn Mawr Trust, copyright 2018, all rights reserved. Visit us online at bmtc.com/wealth.
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